Dow Theory is regarded as the originator of all market technical analysis. The formation of Dow theory is the result of collective wisdom. It is the equipment to improve investors’ knowledge, rather than an all-round strict technical theory that can be divorced from the basic economic conditions and market conditions!
The theory originated in editorials by Charles Henry Dow (1851-1902), a journalist, the first Wall Street Journal reporter, and co-founder of Dow Jones.
It was posthumously summarized by William P. Hamilton, Charles Lear, and E. George Schieffer.
However, Dow himself never used the term “Dow theory”, which came from the later market summary.
Dow theory asserts that prices move in the same direction as the market to reflect market trends and conditions.
There are three kinds of trends in the market: the main trend, the medium trend and the short trend.
1. The principle that the average price is Inclusive of all factors suggests that everything that can affect supply and demand must be reflected in the average market price. Even “natural and man-made” disasters, such as earthquakes or other geopolitical risks, that no one can predict in advance, but which, when they do occur,
It’s quickly absorbed by the market through price changes.
2. There are three trends in the market. According to Dow theory, as long as successive upward price peaks and troughs are correspondingly higher than the previous peaks or troughs, then the market is in an upward trend, and on the contrary, it is in a downward trend.
Dow theory divides trends into three categories: primary, secondary and transitory.
The main trends are those that last a year or more, with most stocks moving up or down with the broader market, typically by more than 20%.
A secondary trend in the exact opposite direction of the primary trend, representing a correction of the primary trend, lasts from three weeks to three months and is one-third to two-thirds of the magnitude of the primary trend.
The common retracement is about half, or 50 percent.
Transitory trends, which last less than three weeks, are shorter-term fluctuations in secondary trends that reflect only short-term changes in prices.
As shown in the following figure: Take gold as an example, from 2005 to 2012, gold was in a general trend of rising, and reached a record high in November 2011. With the gradual recovery of the US economy and the return of the Federal Reserve to the cycle of interest rate hike, gold changed the unilateral upward trend and began to fluctuate down.
After a detailed analysis of the general trend of gold correction in 2012, it can be found that in the main trend, a secondary trend with two rebounds can be found, as shown in the following figure:
From the weekly structure of gold, we can find that although the main trend of gold is in the correction stage, the secondary trend is still rebounding, and the short-term trend is showing signs of rebounding again. Therefore, when we apply the Dow theory, we need to clarify the current cycle of the trading varieties and the trend according to this problem, and then follow the trend.
The first stage is the accumulation stage. For example, at the end of a bear market and the beginning of a bull market, all the so-called bad economic news has finally been absorbed by the market, so the most astute investors begin to buy shrewder and shrewder.
In the second stage, when the business news turns positive, most technical investors start to buy in, and prices start to rise rapidly.
In the third stage, the newspapers are full of good news and good economic news. Mass investors begin to actively enter the market and trade actively. Speculative trading is growing.
4. Averages must verify each other. If only one average price breaks the previous peak, it is not a bull market. Both averages must rise past their previous peak.
If the two averages diverge from each other, then we think the old trend is still valid.
Dow Theory holds that volume analysis is secondary. In short, when prices follow a general trend, volume should also increase.
If the general trend is upward, then trading volumes should be increasing as prices rise and decreasing as prices fall.
Only when there is a clear reversal signal can we judge the end of a given trend.
An established trend has inertia, usually to continue to develop, only when the reversal signal is clearly given, using other technical indicators to assist judgment, we can say that the trend will change, usually always choose “the trend will continue” than the occurrence of the reversal of the stronger.
There are three extremely important assumptions in Dow Theory, which are similar to the three assumptions commonly seen in technical analysis theory. However, here, Dow Theory focuses more on the understanding of its market implications.
Suppose one person is Manipulation — daily or weekly volatility in an index or security can be manipulated. Secondaryreactions can also be limited by this, such as common adjustments,
But major trends are not subject to manipulation.
One might say that the banker can manipulate the main trend of securities.
In the short run, if he does not operate, this fit to operate will be operated by others;
Over the long term, changes in corporate fundamentals continue to create conditions suitable for handling securities.
In general, the main trend of companies is still that they cannot be manipulated, just securities with different institutional investors and different operating conditions.
Assume that the second market index will reflect every piece of information — every market player who knows something about financial matters, all his hopes, disappointments and knowledge, will be reflected in foreign exchange movements;
As a result, market indices will always properly anticipate the impact of future events.
If there is a disaster such as fire, earthquake or war, the market index will quickly assess it.
In the foreign exchange market, all kinds of news are complicated. People constantly evaluate and judge the interest rate meeting of the major central banks, the speeches of the governors, and the main economic data every day, and constantly reflect their psychological factors into the market’s decision.
However, everyone’s knowledge is relatively limited, and they cannot fully grasp all aspects of the foreign exchange market, so the foreign exchange market always seems to be difficult for most people to grasp and understand.
Suppose that the Three Dow theory is objectified analytical theory – the successful use of it to assist speculative or investment behavior requires in-depth study and objective judgment.
When you use it subjectively, you keep making mistakes and losing money.
95% of investors in the market use the subjective operation, the 95% of investors belong to the vast majority of the “seven losses, two even one gain” in the “seven losses” people.
Dow Theory Important Tenets Index confirmation Dow Theory tells us that the market absorbs everything and the butterfly effect tells us that things are universally connected.
The two indices must confirm each other.
The trend can be confirmed only when the two foreign exchange varieties are mutually confirmed, that is, when they show the same or similar fluctuations.
And the behaviour of a single currency variety is not an effective signal of a reversal.
The result of mutual verification is to point to the essence of things, the technical analysis level is not good, the macroeconomic analysis is not good, this kind of analysis is not good.
Policy is not a panacea, should not bet on policy.
When looking at market trends with Dow theory, there are simply no policy options.
In our analysis of Dow Theory-based barometers, we find that a “line” of averages over a long enough period of time, with normal trading volume, where successive closing prices fluctuate within a narrow range must indicate hoarding or selling behavior, and that once the average moves beyond this line (up or down),
It is safe to assume that there will be secondary or even fundamental changes in the direction of market movements.
Dow Theory focuses on morphological analysis.
The reverse form with a bottom or top and the relay form with short – term correction are summarized.
The first target is measured, so the shape is based on the maximum width of the shape space, and the first target of the rise and fall of the broken neck line is the maximum width of the shape space.
After the first goal is reached, the second goal is twice the width, and so on.
The classic Dow theory emphasizes this point.
The foreign exchange market is never constant. It is sometimes very active and sometimes very quiet. It moves up and down in a fixed range. Once the market starts a new move, it usually follows a more fixed path.
Wall Street calls this line the “line of least resistance.”
Do not participate in the operation without a clear trend in the market.
It fits perfectly with the Dow theory, positioning itself in the right place for a secondary correction and not chasing a strong move.
Earn what you can.
Wait patiently to expand the winning fruit when the direction is right, but gradually reduce the number of holdings in a pyramid.
Escape quickly, and once you exceed your stop, you are out immediately.
5. Flaws in the Dow Theory Let’s look at the “second guess” that writers often use when talking about the Dow theory, an accusation that is often repeated (sadly, often) whenever a Dow theorist’s opinions diverges at a critical moment.
Even the most experienced and careful Dow analysts have found it necessary to change their view when a series of market actions do not support their speculative stance.
Dow investors do not dispute this — but they argue that losses from such temporary measures are minimal over a long-term trend.
Sometimes with such highly intemperate comments, the Dow Theory is an extremely reliable system because it causes traders to miss the first third and the last third of every major trend, and sometimes without any intermediate third.
However, the serious lag of Dow theory cannot be ignored, especially in the foreign exchange market, where the market fluctuations change rapidly and time becomes very precious. Therefore, once the opportunity is missed, the market may reverse.
The successful application of Dow theory occurred in unilateral market conditions. For example, when we analyzed the seven-year unilateral bull market of gold from 2005 to 2012, Dow Theory was able to help us obtain better long-term returns. However, when the correction of gold hit the top occurred, we were not completely sure that the main trend of gold would reverse.
Only in the second trend down, when gold breaks through horizontal support, as shown in the chart below: So, in FX and commodities, Dow theory can only help us establish the main trend. We still need to combine other technical indicators to determine what trading strategy should be adopted at this time.
