Tenets of DOW Theory - Foundation of Technical Analysis - Market247.io
If you are a professional financial investor, you will undoubtedly know what Dow theory is, because it is the foundation of technical analysis. Mastering the Dow theory will help investors identify market trends and make the right decisions. So what is Dow theory? What are the principles of Dow theory? How is its application in crypto? Let's find out with Market247.io in this article.
What is Dow theory?
Charles H. Dow developed the Dow Theory. For those who don't know, he founded Dow Jones & Company and served as the Wall Street Journal's first editor. The Dow Jones Transportation Index (DJT), which the Dow Jones Industrial Average followed, was developed by Dow while he was working for the business (DJIA).
Dow Theory is mainly used to predict the direction of a trend by observing how the DJIA and DJTA indexes move. If two indicators move in the same direction by making a series of higher lows followed by consecutive higher highs, the trend is considered bullish.
The Dow Theory is Mr. Dow's opinions, which analysts and commentators later synthesize from his publications and speeches; it does not have a particular book or document. Dow theory is about how the stock market reacts and how to measure financial market health to make a profit. By analyzing the whole, it is possible to accurately assess such conditions and identify the market's main trend.
Tenets of Dow theory
Dow Theory consists of a set of fundamental principles that you need to understand.
Everything is reflected in the market
News on inflation, interest rates, financial statements, investor sentiment, etc., are reflected in the market. All of these factors can affect the market and are reflected in the cost of cryptocurrencies.
Investors cannot know everything, but the information is crucial in predicting future moves. In an efficient market, the price of a crypto asset reacts immediately after breaking news is published, reflecting the impact that information has on market sentiment.
In financial markets, trends are defined as follows:
- An uptrend is when the current trading high is higher than the previous high.
- A downtrend is when the current low is higher than the previous low.
According to Dow theory, the market has 3 main trends:
Main Trend (Long Term)
Major market movements are often of interest to long-term investors. The main trend usually lasts from a few months to several years.
Trend Level 2 (Mid-term)
The secondary trend usually lasts from 3 weeks to several months, is the correction phase of the main trend, i.e., the period when the price goes against the main trend.
These are temporary price coups against the main direction. These corrections are usually one-third or one-half of the main trend.
Trend Level 3 (Short-Term)
Short-term trends usually last from a few days to less than 3 weeks, even seconds. These are small, rapid fluctuations and go against the level 2 trend.
Due to the short-term nature, the level 3 trend is potentially manipulative.
Three phases of the main trend
According to the basis of Dow theory, the main trend consists of 3 stages: Accumulation, Community Participation, and Distribution.
During the accumulation phase, the value of the asset remains lower when a bearish view exists. During this stage, smart investors gradually put their money into buying that asset. As a result, prices began to rise.
After accumulating, the community as a whole joins the trend, the more and more buying volume makes the price go up, making the community more interested. However, these people will not be able to make the same profits as their predecessors.
When marketing continued to give more optimistic information, prices increased sharply. This is the time when investors in the accumulation phase begin to sell their assets to newcomers for a profit. This caused the purchasing power to decrease, and savvy investors also noticed the downtrend and started selling. Accordingly, after they close their position, the market will eventually reverse. The last market participants are often ignorant people with the belief that the price will continue to post but in reality they are "Swinging to the top" and the chances of exit are actually quite slim.
Conversely, for a bear market, the phases of the main trend will move in the opposite direction. When the market leaders notice a decrease in purchasing power, a downward trend, they sell their assets to the last market participants, a lot of bad news is released causing people to sell off.
At this time, the price will plummet to the bottom, smart investors will start buying again, the price will increase and the periods will repeat as above.
Correlation between indexes
Dow believes that major trends in one market index should be determined by trends observed in another.
At the time of this proposal, the major indices in question were the Dow Jones Transportation Index and the Dow Jones Industrial Average. Prior to that, the transport market (mainly railways) was associated with industrial activity. This is because, in order to produce more goods, it is first necessary to increase railway activity to supply the necessary raw materials.
As such, there is a clear correlation between the manufacturing industry and the transport market. If one market grows, so does the other. However, this principle of correlation between these indices is no longer relevant today as many goods are digital and do not require physical delivery.
Trading volume is important
Dow Theory holds that volume is an important indicator of trends. Usually, a strong trend is accompanied by high volume, the higher the volume, the more likely the price movement is to show the true trend of the market. Conversely, when trading volume is low, price movements do not reflect the true trend of the market.
For example, in an uptrend, buying volume increases with rising prices and decreases when prices move in the opposite direction.
The trend will continue until the reversal is confirmed
The last tenet of Dow theory holds that when a market has an uptrend or downtrend, it will continue that trend until there is a clear reversal.
Therefore, Dow believes that trend reversals should be considered until they are confirmed as significant trends. However, it will be difficult for investors to confirm which is the trend reversal and which is only the secondary trend. So trade with the trend if it has not yet reversed.
Dow theory limitation
Let's explore Dow theory limitation right now.
High latency in short-term transactions
In the short timeframes that fluctuate by the minute, not just the day trading like the traditional market used to be, not all trends have three phases like Dow theory. As a result, Dow makes investors lose many profit opportunities in some cases.
Dow Theory doesn't apply much when trading short and medium term
Investors using the Dow theory often spend a lot of time analyzing and finding the main trend because this theory often focuses on the main trend, so investors need to wait for a clear top and bottom. Therefore, investors have missed many medium and short-term investment opportunities. At the same time, this is also detrimental to investors who trade day trading, scalping, or swing trading.
The Dow theory is the foundation of all modern technical analysis knowledge. Therefore, you must first understand Dow theory to be a successful investor in the market. With the help of this article, Market247.io hopes you will be able to respond to the query What is Dow Theory clearly? Drop us a message if you have any inquiries for the quickest response.
Get more information about Dow Theory
Does the Dow theory work?
Although a lot has changed over the past 100 years, the Dow theory and his six tenets are still applicable today and are considered a valid trading strategy by many traders.
Why is Dow Theory critical?
The Dow Theory primarily helps traders identify market trends more accurately to take advantage of potential price action points. It also allows traders act cautiously and not move against market trends.
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