Dow Theory or How Technical Analysis Originated
Good afternoon, friends traders!
In order to fully comprehend the progress made, it is sometimes useful to return to the very basics. Today, technical analysis is taken for granted, and few people wonder what really hides behind well-known market terms. The Dow theory, and Charles Dow himself in particular, can be said to have been at those very foundations. At the same time, at the moment, the postulates of the theory have not lost their relevance. How they can be applied in practical work on the market, in particular on Forex, is in our today's material.
At the dawn of the formation of financial markets, suitable automatic tools did not yet exist, and most of the analysis work was done manually for a long time. That is why in the description of the theory you can notice a lot of attention to details, when now it is customary to omit many details.
A Brief Biography of Charles Dow
Dow's first financial job is as a reporter for the Wall Street news agency. There he met his partner, Edward Jones. Unlike most other journalists, their work was straightforward - Dow and his partner basically did not take bribes.
In 1882, Dow and Jones felt the need for a separate publication. So they founded their own company - Dow Jones & Company, which first engaged in the issuance of daily financial statements.
Subsequently, the two-page booklet grew into a full-fledged newspaper - The Wall Street Journal, which is now one of the most respected publications in the financial environment. The slogan of the publication said that its main goal was to tell the news, but not opinions.
By 1893, there were many mergers, and therefore the share of speculative operations in the markets increased. At this time, Dow saw the need for some indicator of market activity. So the Dow Jones Industrial Average was created, at that time it was a simple arithmetic average of the prices of 12 companies (currently it covers the 30 largest US companies).
Dow drew attention to the fact that much more information is captured in prices than many assume. That is, by analyzing only prices, we can most likely predict their future behavior, which ultimately became the basis of his theory.
Dow Theory Postulates
Price includes everything
Of course, the market cannot take into account events that, by definition, cannot be predicted. However, the price already takes into account the emotions of participants, the economic data of individual companies and states, including indications of inflation and interest rates, and even possible risks in case of unforeseen developments.
In no case does this mean that the market itself or its participants know absolutely everything, and even future events. It only means that everything that happened has already been captured in the price, and any new information will also be taken into account.
A huge number of technical indicators were created on this basis, and today you can find an indicator to analyze literally anything. But while indicators are often used thoughtlessly, Dow analyzed the market as a whole, relying on the natural segmentation of market players.
An extreme reflection of his work is indices of industry and transport. An important role is played by the composition of the index itself. It is not fixed and is periodically reviewed taking into account changes in the situation in the markets. The bottom line is that the stocks of enterprises operating in one area are analyzed. As a result, the index, in some respects, is a closed system in which the bulk of the funds is distributed among the participants and does not go beyond the portfolio.
Three Trends Market
The straightforward movement of the market is science fiction. In fact, the price almost always moves in a zigzag fashion, forming characteristic rising / falling highs / lows. In other words, forming an uptrend or downtrend.
In the market there is a main source trend. It is most important to determine it, since it is the initial trend that reflects the actual direction of the price movement, when all underlying trend levels are dependent on the initial one. The duration of the initial trend is from 1 year to 3 years.
The most important thing is to determine the direction of the initial trend and trade in accordance with it. The trend remains valid until there has been confirmation of its reversal. A prerequisite for a reversal, for example, is closing the price below the previous extremum.
So, the initial trend determines the main direction of the market. In its turn, secondary the trend is moving in the opposite direction to the main trend. In fact, these are corrections to the main trend. The secondary trend has one interesting characteristic - its volatility, as a rule, is higher than the initial movement.
The latter, the smallest trend, is nothing but a pullback of the secondary trend. Such a movement lasts no longer than one week. In the classical representation, he is given the least attention. It is believed that at this time period there is too much price noise, and looping at the slightest movements can lead to irrational trading decisions.
Three phases of a trend
The following postulate of the Dow theory is the stages of trend formation:
- The first phase is usually characterized by price consolidation. This is a period of market indecision, when the previous trend is exhausted. In other words, this period is marked accumulation strength before the jerk and is also the most attractive entry point (albeit risky);
- Once the new direction has been confirmed, the phase begins participation. This is the main phase of the trend, the longest of the three, which is also marked by a large price movement;
- When the motivating conditions have been exhausted, the phase begins satiety. During this period, smart players begin to exit positions as soon as signs of instability appear, for example, increased corrections. This phase can be described as “irrational optimism”, when the price can continue to grow by inertia, despite the absence of obvious reasons for this.
To determine both the trends and the reversals on the chart, it is necessary to understand the methods used by the Dow. The main technique in determining turns is a consistent analysis of extremes. For example, in the picture, points 2, 4 and 6 mark the maxima of the upward movements, points 1, 3, 5 - the minima. An uptrend is formed when each subsequent top and bottom is higher than the previous one.
For a downtrend, on the contrary, lowering highs / lows are characteristic.
Dow theory says that until we get a clear signal for a reversal, the trend remains valid. Here we can draw a parallel with the Newtonian law of inertia, when a moving object tends to move in the intended direction, until another force interrupts its movement. An obvious signal for the upcoming reversal is the formation of a lower minimum (5) as part of the upward movement.
In the case when the trend is down, the situation is the opposite. If the price could not form a lower minimum, and at the same time closed above the current maximum, then the market is affected by the force opposite to the initial movement.
Dow theory, as many hope, does not answer the question “how to enter the market at the stage of trend formation?”. This is a long-term reversal strategy aimed at minimal risk. Nevertheless, the theory helps to better understand the technical analysis as a whole, and why it works at all - because the price is a derivative of all the factors that influence it.