Dow Theory is one of the indispensable parts of the technical analysis process. At the same time, it is also used to determine market trends and make investment decisions. This type of theory investors need to know to have a basic foundation for application in the process of technical analysis. In the article below, Forex Trading will tell you what the Dow theory is. What is its role, how does it work and what should you consider when using it? So, don’t ignore it and refer to this article immediately to understand better!
What is Dow Theory in Forex?
What is Dow Theory that makes so many people interested? Read the information below now to know more.
Definition of Dow theory in technical analysis
Dow Theory is a set of principles used to determine market movements. At the same time, Dow is also considered the premise, foundation, and first systematic basis to develop many important indicators in the technical analysis process. For example, RSI, MACD, Elliott wave, Fibonacci …
This theory was previously researched based on two indicators: industry and railways. Today, although these indicators have changed, the theory can still be applied as a basic theory.
The role of Dow theory in fundamental technical analysis
Charles’s Dow Theory is an important tool for technical analysis in the Forex market. This theory has existed for more than a century and is still relevant to today’s market. Below, are some important roles with basic technical analysis:
Understanding market trends: This type of theory has the ability to help investors understand the direction of market trends. By analyzing basic techniques, investors can easily make wise decisions.
Determine the trend of assets: Dow Theory can help investors determine the movement trend of each type of asset. By understanding the reversal trend of asset prices. Traders can make better decisions about when it is better to buy or sell.
Tools for technical analysis: This is an important tool in technical analysis. Able to help investors identify support and resistance levels as well as important trend lines.
Risk management: By understanding market trends, investors can make adjustments to their investment portfolio.
Forecasting market movements: By combining trend analysis and transaction volume. Investors can make forecasts about the future developments of the market, thereby building an appropriate investment strategy.
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What are the downsides to Dow’s theory?
In addition to the advantages mentioned above, Dow theory also has certain limitations. Specifically:
Based on past data: Technical analysis focuses on analyzing past price and trading volume data. Aims to predict future trends. However, the Forex market is always volatile and influenced by many factors. Therefore, past trends do not guarantee complete repetition in the future. Predictions based on old data can lead to errors and risks for investors.
Ignoring psychological factors: This type of theory is incomplete in analyzing investor psychology. Crowd psychology, panic or too positive expectations lead to sudden drops or increases in prices.
Difficult to apply in strong fluctuations: Dow Theory may have difficulty analyzing and predicting the market. If there are strong fluctuations or unexpected events. These fluctuations will disrupt identified trends. This leads to errors in prediction and affects investors’ investment decisions.
Need to combine with other methods: To achieve optimal results, it is necessary to combine this theory with many different methods. This combined process will help investors have a more comprehensive view of the market. At the same time, it is easy to make wise investment decisions and minimize risks.
Basic principles of Dow theory
This technical analysis process is often based on six principles. Below are 6 types of principles investors should refer to:
Premise Dow theory: What does the market reflect?
Based on this principle, the market reflects many types of available information. Everything you need to know is reflected in the market through the price. Price often represents all the hopes, fears, and expectations of everyone involved. Interest rate fluctuations, earnings expectations, revenue forecasts, and product initiatives. Or all the other things priced in the market. Many unexpected things can happen, but usually this will affect the short-term trend. Traders come here to research future price movements.
What are the 3 market trends in Dow theory?
One of the important pillars of this theory is dividing the market into 3 main trends. Trends are closely related to each other. Below is a specific analysis of 3 types of trends in basic technical analysis:
Primary trend – level 1 in Dow theory
The main trend is the most important trend and dominates the secondary and minor trends. This category represents the general trend of the market, reflecting macroeconomic factors. Or reflects the psychology of long-term investors. This may be an uptrend or a downtrend. On the other hand, the level 1 primary trend in Dow theory is determined by tracking the price movements of the indexes. For example, Nindex, Dow Jones…
Time to form a trend in technical analysis
The time it takes to form a trend in technical analysis can range from 1 to 3 years. Or it will even take longer than the number of years mentioned above. However, there is no exact time for a trend to form. As it will often depend on many factors, including:
- Macroeconomic situation: When the economy grows strongly, an upward price trend can form faster. Conversely, during a recession, the downward trend may last longer.
- Investor sentiment: Investor optimism can accelerate the price uptrend. While pessimistic sentiment can prolong the downtrend.
- Unexpected events: Unexpected events such as natural disasters, war or financial crisis. Can suddenly change market trends.
Level 2 trend – secondary trend in basic technical analysis
The secondary trend corrects the main trend and creates highs and lows within the main trend. This type has a shorter term than the main trend. This trend usually lasts from a few weeks to a few months. Level 2 trends move in the opposite direction of the main trend or correct the main trend. This reflects news factors and short-term economic events. In addition, this type also helps identify entry and exit points into the market within the main trend.
What is a level 3 minitrend in Dow theory?
Minor trends create noise for the primary and secondary trends, but can provide short-term trading opportunities. This is the shortest trend, lasting only a few days or weeks. This type will move in the opposite direction to the main trend or correct the main trend. This process reflects short-term price fluctuations due to news and temporary investor sentiment.
Principle 3: 3 main trend periods in technical analysis
The main trend of the Forex market usually has 3 different stages of development.
Each period will reflect different volatility signals.
An uptrend includes 3 stages:
- Accumulation phase: During this phase, the market fluctuates quite slowly and will almost remain unchanged. This stage is usually at the end of a downtrend, asset prices at this time are low. This stage is difficult to perceive, so it is difficult for investors to realize whether the downtrend has ended or not.
- Boom phase: This phase is when prices are likely to begin to increase sharply. Investors should buy and wait for the opportunity to explode.
- Transition phase: This phase will usually signal the highest increase and begin to gradually weaken. Some investors may gradually sell assets.
The downtrend also includes 3 stages:
- Distribution phase: This phase starts a downtrend as investors continue to buy. However, whether prices will actually increase is uncertain.
- Despair phase: The time when a lot of bad news is released, causing investors to fall into a state of confusion. At this time, we will try to find a way to sell off assets to make a profit.
- Collapse stage: In this stage, the market enters the ruin stage. Investors sold off, causing prices to plummet. At this point, the accumulation phase will begin repeating the new trend.
Principle 4: Mutual confirmation of averages in Dow theory
Market reversal is determined by two industrial and railway indexes. This means that the signs occur on the graph of this indicator. Will correspond to signs occurring on the graph of some other indicators. These two indexes are the industrial average index and the railway index.
Principle 5: The condition for trend confirmation is trading volume
Trading volume increases depending on each trend in the market. Usually based on trading volume, the strength or weakness of the trend is determined. If you see an increase, the trading volume will also increase, and vice versa. However, in some cases, the trading volume will go against the trend. This process shows the weakness of the trend in the near future.
Maintain the trend until there are signs of reversal in technical analysis
Maintain the trend until you see signs of reversal in technical analysis. This means that investors should patiently observe to see signs of reversal. From there, effective trading strategies can be devised.
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What factors should be considered when using Dow theory?
To effectively use the Dirty theory, you need to pay attention to the following factors:
Pay attention to closing prices and the amplitude of fluctuations in technical analysis
Closing price and fluctuation range are two important factors in technical analysis. Used to evaluate market trends and predict future prices.
The closing price is the last trading price of an asset during a particular trading session. This is considered important because it reflects market psychology at the time the market closes. If the closing price is higher than the previous session’s closing price, it may be a sign of an uptrend. On the contrary, if the closing price is low, it can be considered a sign of a downtrend.
The fluctuation range is the degree of price fluctuation of an asset during a trading session. High fluctuation amplitude shows strong market fluctuations. While the fluctuation amplitude will be lower than that of a stable market.
Trends and signals identified in Dow theory
Dow Theory is based on the idea of markets moving in trends. However, market trends will change over time. So this theory cannot always accurately predict changes. Therefore, it is recommended to combine some of the following trends to determine the exact signal trend.
Primary Trend in Basic Technical Analysis
Primary Trend is the longest-term trend in the price of an asset. It usually lasts for several months or years. It is shaped by macroeconomic factors such as GDP growth, interest rates, and general market sentiment.
When doing fundamental technical analysis, it is important to buy when prices are rising and sell when prices are falling. Investors should also use stops to limit losses if prices move.
Mid-term trends with technical analysis
A medium-term trend is a trend that has a shorter duration than the primary trend and longer than the short-term trend. It can usually last from a few weeks to a few months. Mid-term trends are formed by technical factors such as retracements.
Mid-term trends are important for trend-following investors. Because it can provide them with detailed information about the direction of the market. By identifying the medium-term trend, investors can adjust their trading strategy. To take advantage of potential opportunities and limit risks.
Short-term/secondary trend
This trend usually lasts from a few days to a few weeks. Short-term trends are formed by market psychological factors and short-term news events. This type is considered very important for short-term traders. Because it gives them insights into the direction of the market. By identifying short-term trends, traders can take advantage of price movements.
When using this trend for short-term trading, it is important to buy when the price is rising. Traders should also use stop losses. To limit losses if the price moves in the opposite direction of the trend.
Important factors in technical reversal analysis
Technical reversal analysis is a method of predicting changes in the current trend. Accurately identifying turning points can help investors profit from market fluctuations. However, it is important to note that no method is guaranteed to be 100% accurate. Therefore, trend reversal can be influenced by many different factors. For example, price, volume, trend lines, and technical indicators.
Conclude
Dow Theory is a valuable tool for investors in their technical analysis. But it’s important to be aware of its limitations and use with caution. Therefore, investors should combine basic technical analysis with other analysis methods. At the same time, stay updated with new market news and events to make investment decisions. Hopefully after reading the above article of Forex Trading. You have a somewhat better understanding of Dow and technical analysis. If after learning information about technical analysis you have any questions, please contact us immediately.
FAQS
What are the 3 types of trends of Dow theory?
The three main trends of Dow theory include primary trend, secondary trend, and minor trend.
What factors influence technical analysis?
Factors affecting Dow theory include inflation, interest rates, investor emotions…
What technical indicators should Dow Theory be combined with?
Dow Theory can be effectively combined with technical indicators such as volume indicators, trend indicators, momentum indicators, divergence indicators…
