Dow Theory – Foundations of Technical Analysis
Those who have studied technical analysis know that much of the concepts of technical analysis has been derived from the Dow Theory contributed by Charles Dow. The theory was initially applied to stock markets but the concepts are applicable to all markets and form the basis of technical analysis.
The Six Basic Tenets of the Dow Theory
- Averages discount everything – this is the same as price or market action discounts everything
- The market has three trends – primary, secondary and minor. We will see this while studying trends in the FX markets. In brief, the theory considers the major trend to last for more than one year; the secondary trend represented corrections in the primary trend and usually lasted for 3 weeks to 3 months, these are retrenchments of the primary trend and could retrace 33.33% or 50% or 66.66%, we will study this when we look at Fibonacci numbers; The minor trend usually lasts less than 3 weeks andÂ represents short-term fluctuations in the secondary or intermediate trend.
- Major trends have 3 phases – accumulation, distribution and speculative. Contrarians accumulate when everyone is selling and pessimistic, start distributing when no one is selling, ie the speculative phase when the market is too good to be true.
- The Averages must confirm each other – Here Charles Dow meant that no important bull or bear market could take place unless all the averages – the Industrial and Rail also confirm the same signal. Higher peaks during bull runs or lower troughs during bear runs.
- Volumes must confirm the trend – this simply states that if the trend is up it should be backed by high volumes in the same direction. If the prices move down in a bull run then volumes should be lower in that direction. The same with the bear run. Volumes should be high when prices fall and low when prices rise.
- A trend is in effect until it has given definite signals of reversal – this is the basis of technical analysis that we have discussed. However trying to identify reversals are not easy as we shall see when discussing reversal patterns such as the failure swings, non-failure swings, head, and shoulders reversals or oscillators that warn us of reversals in momentum.
You can watch the free training video on Dow Theory here
Next, we study various types of charts and the construction of these price charts – Bar chart, Line Chart, Candlestick Charts
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