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Part II. Technical Analysis / Chapter 2. Dow Theory
In this chapter, we will study Dow Theory, which serves as the foundation of technical analysis in financial markets. Originally, Dow Theory described the behavior of stock prices over time and was developed specifically for the stock market. However, with a certain degree of confidence, the principles of Dow Theory can be applied to other financial markets, including the Forex market. The theory is based on a series of publications by Charles Dow (Charles H. Dow, 1851-1902), an American journalist, the first editor of "The Wall Street Journal," and the founder of the renowned "Dow Jones & Company" corporation. Dow's works were studied and consolidated after his death, forming the basis of Dow Theory. It's worth noting that Charles Dow himself did not use this term during his lifetime.
Dow Theory consists of six postulates. While each postulate primarily relates to the stock market, it can also be partially applied to the Forex market.
Postulate 1: There are three types of trends in the market: primary, secondary, and minor (also known as long-term, intermediate, and short-term trends). Each type of trend can be either upward or downward. Charles Dow defined a trend based on the positioning of peaks and troughs on the chart. In an upward trend, each subsequent peak and trough should be higher than the previous one. In a downward trend, each subsequent peak and trough should be lower than the previous one.
Postulate 2: Every primary trend consists of three phases , as identified by Charles Dow. These phases are the accumulation phase, the participation phase, and the distribution phase. The accumulation phase is characterized by experienced investors buying (or selling) stocks contrary to market sentiment, utilizing large capital. This phase is usually short-lived, driven by certain fundamental events, and does not result in significant price fluctuations. The accumulation phase is followed by the participation phase, during which active traders identify the emerging trend and join it. This leads to price changes that strengthen the established trend. The participation phase is then followed by the distribution phase, in which nearly all market participants recognize the strength of the established trend and begin opening positions in the favorable direction. This process results in substantial price changes. In this final phase, experienced investors, sensing an upcoming trend reversal, start moving in the opposite direction and close their positions opened during the accumulation phase. As a result of their actions, the strength of the trend diminishes.
Postulate 3: Stock market indices should confirm each other. This refers to the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). According to Dow theory, the current trend and signals of trend reversal should be confirmed by both stock market indices. Some divergence in signals over time is allowed, where one index may give a signal of trend reversal with a certain lead time compared to the other.
Postulate 4: Trends should be confirmed by trading volume. According to Dow theory, the development of the current trend or the formation of a new trend should be accompanied by increasing trading volume. When price changes occur with low trading volumes, they may not characterize a trend as they do not reflect the opinion of the majority.
Postulate 5: The stock market reacts to all news. Charles Dow believed that stock prices react to any new information. This applies not only to the publication of financial indicators and economic news but also to any other news in general, including rumors.
Postulate 6: A trend will remain in effect until there are clear signals of its reversal. According to this simple postulate, a trend will eventually reverse. However, if price changes occur hesitantly, it can be interpreted as a temporary correction rather than a trend reversal. Determining a trend reversal is a challenging aspect of technical analysis and a key task for every trader.
As can be seen, while Dow theory establishes the foundation of technical analysis, it carries a philosophical nature. The practical application of Dow theory will be explored in the following chapters of the information portal. As mentioned earlier, Charles Dow studied the behavior of stock prices, not currency exchange rates. Nevertheless, some of the postulates of Dow theory can be confidently applied to the forex market. This is because all financial markets are interconnected in one way or another, and human psychology plays a role. After all, prices in financial markets are driven by traders themselves in the ongoing battle between bulls and bears, and the psychology of traders in different financial markets is similar.