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What is Dow Theory? Principles and trader assessments

Dow Theory is an important part of the forex market analysis platform that investors cannot ignore. Understanding this theory helps investors analyze and predict market developments more accurately and effectively. So what is dow theory? What is the principle and how to apply it? Let’s explore Forex Trading in the article below.

Concept what is dow theory?

Dow Theory is a set of six basic principles that explain how the foreign exchange market works. Charles Dow developed these principles. And published them in articles in the Wall Street Journal from 1900 to 1902. However, only after Dow’s death, plus the efforts of William Hamilton, George Schaefer, and Robert Rhea. These principles were recently organized and reformulated into the Dow Theory.

Concept what is dow theory?
Concept what is dow theory?

6 important principles of what is dow theory?

Dow Theory is the oldest and most popular technical analysis theory today. 6 important principles of what is Dow theory? Let’s find out now.

Principle 1: The market can reflect everything

According to this principle, the market already reflects all available information. All necessary information is reflected in prices by the market. Price represents the sum of the hopes and expectations of all parties involved. Interest rate fluctuations, earnings expectations, revenue forecasts, and everything else are already priced into the market. Although there may be unexpected fluctuations, they are usually only short-term and do not change the main trend. Traders can study these price movements to predict the future trend of the market.

Principle 2: 3 trends follow what is Dow theory?

According to Dow Theory, the market always experiences three different types of trends. Includes main trend (level 1), secondary trend (level 2), and minor trend (level 3).

  • Main trend (level 1): This is the trend that receives the most attention and lasts from 1 to 3 years. This trend is divided into two types: bullish and bearish. It is difficult to predict and is not governed by any organization or individual.
  • Secondary trend (level 2): ​​Last from 1 to 3 months, this trend is always opposite to the main trend. If the main trend is up, the secondary trend will be down, and vice versa.
  • Minor trend (level 3): Short time no more than 3 weeks. This trend is often unclear and susceptible to noise. However, nimble investors can also take advantage of this trend.

Principle 3: Market trends always have three stages

Whether the market is going up or down, all developments go through three main stages. So what are the three stages in what is Dow theory? Below is an analysis of these three phases.

Accumulation phase

After a series of sharp declines, the market often enters an accumulation phase. Here, many investors have lost faith in the price increase. Although prices may have hit a cycle bottom, hesitation still leaves buyers hesitant. During this period, large investors and funds begin to accumulate stocks at low prices. Creates a new support level and lays the foundation for the next phase.

6 important principles of what is Dow theory?
6 important principles of what is Dow theory?

Growth phase

This is an exciting period when short-term traders see growth potential and enter the market. Buying from this partner pushes the asset price up rapidly, establishing a strong uptrend. Positive news about the market also stimulates public participation, boosting growth momentum.

Distribution phase

When prices reach new peaks, investors pour money into the market. However, large investors began to sell their holdings. Leading to the distribution and formation of resistance levels. At the same time, the selling momentum from large investors made it impossible for the price to surpass the high mark and eventually led to a downtrend.

Principle 4: According to dow theory: indicators must determine each other

To evaluate an established trend, there must be consistency among all market indicators. This means that the movements of one index need to accurately reflect the direction of all other indices. These indicators are very important in trading such as Swing Trading. Only when this consensus is achieved can we make an assessment of the market’s direction? Whether it is increasing or decreasing in each specific case.

For example, let’s say VNINDEX is moving mainly in an upward direction. While HNX30, VNI100, VNI Midcap, and many other indexes in the market are mainly going down. In this situation, it cannot be concluded that the market is bearish (going down). Only when all indicators move in the same direction can we clearly identify the trend?

Principle 5: Trading strategy consistent with price trend

According to this principle, every major trend in the market, whether bullish or bearish, is supported accordingly by trading volume. For example, during a bull market, trading volume will increase when prices rise and decrease when prices fall. In other words, there are more trades in the primary uptrend than in the secondary downtrend.

Principle 6: The trend is maintained until the market shows signs of reversal

Charles Dow realized that it is easy to confuse secondary trends and trend reversals. This is because both types of price movements move against the main trend. For example, when the market is predominantly bearish. A short-term price increase can be misleading as a trend reversal. This can also be one of the manifestations of the Bull Trap. If you don’t clearly understand what is a bull trap, learn it now to trade more effectively.

The trend is maintained until there are signs of reversal
The trend is maintained until there are signs of reversal

However, this could also just be part of a secondary trend. Therefore, according to Dow’s theory, it is necessary to continue to view the market as bearish until a clear uptrend is identified. Only then can it be considered a trend reversal, causing the market to turn bullish.

See more: Learn Dow theory for trading beginners

Trader’s review of Dow theory application

Traders’ reviews of the application of Dow theory can be quite positive. However, it should be noted that Dow theory is not a perfect tool. And sometimes situations may be encountered that are inconsistent or deviate from reality. Here are the pros and cons of this theory.

What is the advantage of what is Dow theory?

Dow Theory offers several important advantages in market analysis, including:

  • Trend recognition: Helps traders recognize and determine market trends accurately. From there, you can take advantage of effective trading opportunities.
  • Be cautious and follow trends: Encourage caution and follow market trends.
  • Focus on closing prices: Emphasize the importance of closing prices as a good indicator of overall market sentiment. Helps traders have an overview and accurate view of market developments.
  • Reflects market psychology: Helps identify market reaction and investor psychology through closing prices.
  • Easy to apply: It is a simple and easy-to-understand market analysis tool. Suitable for many traders from beginners to experienced investors.

What limitations does Dow Theory have?

Dow Theory has useful applications in evaluating the forex market. However, this cannot be considered a perfect method. What are the limitations of Dow theory according to traders? Let us analyze it below.

  • Limited prediction ability: Dow Theory only helps investors identify current market trends.
  • The influence of psychological factors: Investor psychology can change market trends, something that Dow theory does not take into account.
  • Need to combine with other technical analysis tools: Dow theory is important but not enough. Investors need to combine it with other technical analysis tools to have a more comprehensive view of the market.
Trader's review of Dow theory application
Trader’s review of Dow theory application

See more: XTB: The most reputable and quality broker in UK

How to effectively apply Dow theory for technical analysis

Dow Theory provides a useful approach for traders. When analyzing market trends and making trading decisions. The principles of this theory can be applied to all types of markets, including the foreign exchange market.

Here are some ways to apply Dow theory in technical analysis:

  • Use leading indexes to identify main trends: Indexes such as Dow Jones, S&P 500, and Nasdaq are indexes that reflect the overall economic situation of the United States. When these indicators increase, it can be concluded that the general market trend is going up. On the contrary, when these indexes decrease, it can be concluded that the general market trend is going down.
  • Use trading volume to confirm trends: Trading volume is an important indicator to confirm trends. When trading volume increases during an uptrend, it can be understood that the trend is getting stronger. Conversely, when trading volume decreases in a downtrend, it can be understood that the trend is weakening.
  • Use price models to determine entry points: Models such as triangles, pennants, and flags often appear on the market. Traders can use these patterns to determine appropriate entry points.

Conclude

Above is the detailed information about what is Dow theory that Forex Trading wants to share with everyone. Dow theory is commonly applied in financial markets. Including forex and cryptocurrency markets. If you are interested in using this technical analysis method. Understanding the principles presented will help you invest more effectively.

Frequently asked questions

How to apply Dow theory to trading?

To apply Dow theory to trading, you can: Follow major market trends. Use commodity indices to determine their correlation. 

Does Dow Theory influence long-term investing?

Although Dow theory focuses on short-term trend analysis. But its fundamentals can also be applied to long-term investing. Understanding and tracking key market trends can help make long-term investments effective.

The market fluctuates strongly, is the Dow theory still effective?

Although markets can experience extreme volatility, Dow Theory provides investors with a basis for understanding and reacting to these fluctuations. Tracking major trends and learning about correlations between commodity indices can still be helpful in making trading decisions.

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