- The direction of transactions in the market shows the collection of past information of the market and leaves its influence on the averages (indices).
- In price charts, we encounter three types of upward, downward and neutral trends.
- Major price trends have three stages of consolidation, general participation, and distribution.
- Another preliminary principle of this theory is that indicators should confirm each other.
- According to Dow’s theory, in technical analysis, the volume of transactions should support the trend.
- Trends continue to move until definitive reversal warnings are received.
The history of the origin of technical analysis states that in 1882, Charles Dow founded the Dow Jones Company with his business partner Edward Jones. At that time, he published his ideas in the form of articles in the Wall Street Journal, and today, after about a century, most technical analysts and capital market researchers believe that the basis of what is known today as technical analysis is actually These are the same theories that were presented by Dow many years ago.
On June 3, 1884, the first stock market index, which was obtained from the average closing price of 11 companies, was published by Dow. Of these, 9 companies were related to the railway industry and 2 companies were related to manufacturing factories. Dow found that the average closing price of the shares of these companies can be a good basis for diagnosing the country’s economic situation.
In 1897, Dow divided this index into two parts, one was the index of twelve industrial companies and the other was the index of twenty railroad companies. Twenty one years later, in 1928, the number of companies influencing the industry index reached 30. Following this path, the Wall Street Journal presented several indicators. To fully learn technical analysis, we suggest you to participate in the technical analysis course of Rahvard Academy.
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Preliminary principles of Dow theory
1. Everything is included in averages (indices).
The direction of transactions in the market shows the collection of past information of the market and leaves its influence on the averages (indices). There is no need to compile a set of information on commodity prices, bank transfers, stock fluctuations, and the volume of foreign and domestic transactions; Because all these items are included in the price chart. This principle is one of the basic assumptions of technical analysis and is true even for specific markets and market averages.
2. There are three types of trends in the market as follows:
- upward trend
- downward trend
- Neutral process
In an uptrend, the price may fluctuate up and down many times, but ultimately, the result of these fluctuations has a positive slope. This definition provided by Dow is the basis of the price trend in technical analysis. As you can see in the chart below, although the general trend of the price is upward, but in the meantime, the price has experienced a lot of upward and downward fluctuations.
Dow believed that the laws of action and reaction are true in the capital market as well as in the material world. He believed that when the share price rises to a great extent, then the share will adjust its price and then return to its highest price range. If the share cannot approach its high price in this movement, it will be condemned to further decline.
According to Dow’s theory, each process consists of three other processes:
1- Primary process 2- Secondary process 3- Small process
The primary trend represents the current that governs the entire trend, and the secondary trend actually includes the waves that complete the current. According to Dow’s theory, currents can even last for years. The secondary trend is actually a correction of the primary trend (flow) and in it, prices are often corrected by one-third to two-thirds of the previous trend. The small trend also shows the fluctuations that occur in the secondary trend. 3. Big trends have 3 stages.
Charles Dow focused more on the initial process, which includes 3 stages as follows:
Condensation or aggregation stage
Smart and knowledgeable investors enter the market in the consolidation phase. If the previous trend was downward and the obstacles and news that led to the price decrease are decreasing, they will buy. On the contrary, if the trend was upward before that and the factors and news that led to the price increase are decreasing, they sell. This stage in technical analysis is called wholesale stage and technical analysts can recognize this stage and buy and sell in the best price range.
Public participation stage
The public participation stage is when most analysts start investing. The beginning of this stage is when the price starts growing rapidly and the economic news also improves.
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The distribution stage is the time when newspapers begin to widely publish economic news and positive analysis. At this time, the volume of transactions increases during public participation. Smart and knowledgeable investors who started buying at the end of the price decline, start selling at the end of the price rise and before the recent buyers are ready to sell.
4. Indicators must confirm each other
According to Charles Dow’s theory, regarding industry and railroad indicators, any sign or warning is important when both of these indicators (industry and railroad) show a similar warning or sign and confirm each other. He found that the condition for the beginning of the upward trend is that both indicators are above the second wave (the highest figure of the wave).
According to Dow theory, it is not necessary for both warnings or signals to be issued at the same time, but the shorter the interval between them, the stronger confirmation of trend detection will be obtained. Dow also found that whenever the two indices diverge (move opposite to each other), the previous trend will continue to hold.
5. The volume of transactions in technical analysis should confirm the trend
According to Charles Dow theory, trading volume is a secondary but important factor in confirming warnings derived from price analysis. To put it simply, the volume of transactions should be in line with the direction of the main trend. In large uptrends, trading volume should rise along with rising prices. In downward trends, the trading volume decreases during upward fluctuations and increases during downward fluctuations.
Undoubtedly, the volume of transactions is considered an important factor in decisions. Knowledgeable traders check for confirmation of the two by comparing trading volume information with price changes. As you can see in the graph below, the volume of transactions is high in the upward trends aligned with the main direction and decreased in the downward trends.
6. The trends continue to move until they receive definitive warnings of return
This principle states that anything in motion tends to maintain its direction of motion unless an external force causes it to change direction. This principle is in fact the foundation of technical analysis (trade in the direction of the trend). Dow’s main emphasis is on closing prices, and in his opinion, prices should be higher than the previous peak or lower than the previous downward wave to be meaningful.
Dow never intended to use this theory to predict market movements. His idea was to use these theories to determine the general state of investment.
Criticisms on Dow’s theory
Although the Dow theory has been very successful in identifying rising or falling markets over the years, there are also criticisms of these theories. On average, 20-25% of market movements are not visible by Dow theory before a buy or sell warning occurs. A buy alert can often be received during the second bullish phase or the second bullish rally using the Dow Theory.
That is, when the price in the second bullish rally is higher than the peak of the previous bullish rally. Meanwhile, at this stage, most technical systems based on trends begin to identify and participate in the existing trend. It should be noted that the Dow has never claimed to predict trends and has merely looked for the emergence of bullish or bearish markets with the intention of capturing the large middle portion of important market movements. According to the available documentation, Dow’s theory has performed this important task well.
During the years 1920 to 1975, he was able to predict 68% of the price changes of the transportation industry indices and 67% of the changes of the S&P 500 index. Those who believe that his theory cannot lead to profitability, are in fact unable to understand the basic concepts of trends. To get technical information, I suggest you read the technical analysis training article.