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What’s the Dow theory?
Technical analysis briefly
Technical analysis is a universal method of analysis that applies to financial markets, stock markets, futures, options, and currencies. The basis of modern technical analysis is the Dow theory. Charles Doe was an American journalist, creator of the world-famous financial publication The Wall Street Journal and the Dow Jones Index, and co-founder of Dow Jones and Co.
History of Dow Theory
In the nineteenth century, Charles Dow was the founder and editor of the Wall Street Journal, as well as a co-founder of Dow Jones & Company. As a member of the corporation, he contributed to the development of the Dow Jones Transportation Index, the first stock index (DJT). He also described a market behavior hypothesis that is still in use today. The notion that the market could be anticipated only through the use of charts was innovative, and many 20th-century investors slammed it right away. What cannot be claimed now is that people make money in all kinds of markets using technical analysis based on Dow’s theory, supplemented with a variety of tools.
What is Dow Theory?
Charles Dow’s theory is a theory that describes the behaviour of stock prices over time. The postulates of this theory form the basis of the methods used by investors around the world, working both with the stock and index markets and with the foreign exchange market. At the heart of this theory are the studies of Charles Doe, which describe the behavior of stock prices that change over time. Such a concept as the Dow theory appeared after the death of Charles, and it was supplemented by other authors.
How Dow theory works
The Industrial and Transportation (Dow Jones) indices should confirm each other when the trend changes. If no such confirmation is observed, then there may not be a reversal. Trends should be confirmed by volume. Dow believed that a trend was confirmed if stock prices rose and trade increased with them. For a qualitative assessment of the market, it is always necessary to build a joint graphical model – a trading volume histogram on the price chart. The histogram structure includes bars of different heights. Each bar corresponds to its own trading period, which depends on the selected scale (1 minute, 5 minutes, 25 minutes, etc.). The higher the bar height, the higher the speed at which the market-maker updates the quotes.
Each bar of the histogram corresponds to one chart figure (bar or candlestick), which determines the trading volume for the trading time (trading interval). The histograms are placed under the price chart.
The trend will continue until there are unambiguous signals of its termination. The author believes that the market will most often continue to move in the current trend, rather than change it. A trend change will occur only if there is an unambiguous signal about it: a breakout of trend lines and closing prices outside of it. There are three types of trends: primary (long-term), secondary (or intermediate), and small (or short-term). And a trend always has a direction. It can be: ascending, downstream and lateral (flat).
Principles of Dow Theory
Dow Theory consists of the following principles. A trend has three phases: accumulation, participation, and implementation. The accumulation phase is when investors start buying or selling an asset. But there are few such investors and they cannot contribute to the organization of the trend. At the stage of participation, traders begin to open deals on a new trend, which then gains strength.
And after the trend has arisen, the rush of buying or selling begins. When the price peaks, the investors close and get a good profit from it. After that, the trend starts to reverse. In the event that new traders support the trend, the trend will continue, if not, then a reversal will occur. The price takes into account everything. This means that the market price displays everything that can affect the supply and demand of the market. Indexes must be consistent.
What is needed
The first thing you need to trade on the Dow Theory is a trading platform. Today there are a lot of companies that offer such services. Some of them even have a Demo mode that allows users to practice first. Dow theory states that certain stock indexes must be consistent with one another. This statement directly applies to indices such as the Dow Jones Industrial Average as well as the Dow Jones Transportation Index. According to the theory, the trend that has already formed and signals about its change should be confirmed by both indices. By the way, sometimes differences between the signals are allowed here, for example, one can come earlier than the other.
These principles are universal, and they must be studied by every trader who trades through technical analysis of the market since they are technically analyzed in the postulates of Charles Doe.
We would like to present you one of the possible variants for proving Dows axiom, based on the analysis of commercial structures profit on the real competitive market of goods and services, because the main goal of any commercial structure is profit and Forex is not far away from the real market of goods and services. It is known that the most obvious, simple, radical, reliable and unquestionable way to determine profit (P) is its representation as the difference between income (E) and all kinds of expenses (P):
P = E – P
Expenses (P) are variable (Pper), dependin on income (E), and constant (Ppos), independent of income:
P = Pper + Ppos
Therefore, the profit formula is usually represented as
P = E – Pper – Ppos
Using the definition of variable costs as Pper = K*D, we obtain, where K is the coefficient of proportionality, we write
P = (1-K)*D – Rpos
Expressing Profit (E) as the product of the volume/quantity of goods (V) and its selling price C, we obtain the following formula for determining profit in the traditional way
P = (1-K)*V*C – Ppost (1)
Any person looking at this formula (1) will exclaim: the profit depends on both the volume and the selling price of the commodity! And he would be right.
But, some sources shows how to derive an alternative formula for profit taking into account the provisions of the law of supply and demand, which coincides exactly with the traditional formula (1):
P = A*(Ts^2 – 2*Cp*C + Tsopt^2)/C (2)
Here, A, Tsr and Tsopt are constant coefficients calculated experimentally on the basis of actual trade data within selected data sample, where A>0 for monopolistic and A<0 for competitive markets, Tsr is market price and Tsopt is optimal sales price providing maximum profit.
Based on the absolute equality of the formulas (1) and (2), we conclude that the Dow prophecy in the form of the first axiom can be a proven theorem as it contains no other variables besides the price, and traders and market researchers can safely rely on the price analysis in their market research without being distracted by other market parameters.