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Introduction to Dow Theory: Fundamental Theory of Technical Investing
Dow Theory, developed by Charles Henry Dow over a century ago, remains a timeless concept in technical analysis by providing a framework for understanding price trends. This theory comprises six key principles:
- Prices Discount Everything: Dow Theory explains that all factors affecting the market, including fundamentals, news, events, and market sentiments, are already reflected in the price. Therefore, technical analysts believe that they should trade based on what the charts are showing, rather than personal opinions or biases.
- Market Indexes Must Confirm Each Other: Various factors used in trading analysis, such as macroeconomic factors, economic indicators, and specific asset fundamentals, as well as technical analysis, can all be used together for profit opportunities.
- Volume Must Confirm The Trend: Volume, or the trading activity, helps confirm whether a price trend is supported by market participants or controlled by a few. A stable price trend typically needs substantial trading volume to support it. If the volume is low, the price movement may be temporary.
- Trends exist until definitive signals prove that they have ended: Prices can trend upwards, downwards, or even sideways. As long as a trend persists, traders can continue to hold the asset. However, if the trend reverses, it’s crucial to react accordingly.
- Market Trends Have Three Time Frames: Markets move through three main trends: the primary trend (lasting 1-3 years or more), the intermediate trend (lasting 3 weeks to 3 months, or more), and the minor trend (daily, monthly, or longer). Understanding these trends will help you plan your investments accordingly.
- Market Trends Have Three Phases: These phases include the accumulation phase, where the general public is not very interested; the public participation phase, where more investors start to buy in; and the distribution phase, where the early investors start to sell.
Understanding these principles is crucial for traders, as they form the foundation of technical analysis and guide trading strategies.