Dow Theory – the basics of technical analysis.
Dow Theory is a theory of financial market behavior that can be applied to currency, stock and commodity markets. At the same time, it was developed exclusively on stock market. Dow Theory contains the following postulates: the trend has three phases, the price discount all the news, trend is confirmed by volume, averages must confirm each other. Also there are many other theories on the works of Charles Dow, but the above theories can be considered basic.
Dow theory can be surely called the progenitor of technical analysis, because these theories can be found to some extent in most modern market theories. At the same time, despite global computerization, these theories also remain relevant, since they fully explain the very nature of the market.
A little bit of history
Charles Dow and Edward Jones worked at the Wall Street News Bureau, where they met and founded later the Dow Jones & Company in 1882. This company eventually turns into a full-fledged newspaper The Wall Street Journal, which is still one of the most authoritative publications in the world.
In 1893, Dow created the DowJones Industrial Index, which is further transformed into DOW 30 and includes the so-called “blue chips”. During the period from 1851 to 1902, Charles Dow published series of articles, on the basis of which theories will be developed in the future, that will be called Dow theories.
Trend has three phases
According to the Dow theory, any trend has three phases. You can find many features and conditions while studying works of Charles Dow and other authors. It will significantly complicate the perception of the material, so the theory will be presented as simply as possible without losing the basic idea.
A trend has three phases: accumulation, participation, and distribution or saturation.
- Accumulation implies a kind of consolidation of prices in a narrow trading range, flat. Such periods in the market are often called lull, when there is virtually no clearly defined trend, and the price moves in the established side range. At the same time, market participants gradually accumulate trading volume before the move.
- Participation is a phase of direct movement of the market, which can be caused either by some actions or by the critical accumulation of trading volume. This ultimately determines the movement of the market in a particular trend.
- Saturation is answered by that part of the trend, when the price moves to a correction, and the driver that determined the trend has exhausted itself. Investors in this phase are closing positions and leaving the market, thereby reducing the trading volume and slowing down the trend.
The yellow zone is accumulation, the blue zone is participation, the green zone is saturation.
Summing up, we can say that any trend can be divided into three zones: formation, working out and correction. Each zone has its own characteristics and conditions. It allows to predict the future price behavior in one way or another. At the same time, many tactics and theories are based on this model of movement.
In the next article we will look at the theory: “the price discount all the news”.