3.03 Dow theory: assumptions and theorems

Dow theory is an integral part of technical analysis. Before the Western world became familiar with candlestick charts, the theory was widely used by investors and traders. In today's trading world, we combine the best practices of candlesticks with Dow theory.

This lesson will help you learn about the principles and theorems of Dow theory.

Content 

• Charles Dow - pioneer of technical analysis

• Basics of Dow theory

• Dow's theorems

 

Charles Dow – pioneer of technical analysis

From 1851 to 1902, Charles Dow was born in the United States. He was a financial journalist who was passionate about the stock market. He founded Dow Jones & Company and co-founded The Wall Street Journal, a newspaper that is still famous today.

Charles Dow was also the creator of two stock market indexes, the Dow Jones Industrial Average and the Dow Jones Transportation Average, related to railroad companies. All of Dow's ideas and thoughts on the stock market were published in The Wall Street Journal. Charles Dow never tried to create any theories in his publications. After his death, all his writings were collected and called the Dow Theory.

Charles Dow's friend, Samuel Armstrong Nelson, was the first person to take an interest in Dow's concepts. At the beginning of the 20th century, he published a book called “The ABCs of Stock Market Speculation”, which contained many of Dow’s ideas.

 

Fundamentals of Dow theory

Dow's advocates classified several principles derived from his theory. You may notice that all the assumptions of Dow theory are still valid today, but need some clarification. So let's now discuss the three principles of Dow theory.

 

First rule

Manipulation on the stock market is only possible in the short term, as it is too difficult to manipulate long-term trends. Although various manipulations occur every day, it is almost impossible to influence major trends that last several years.

One person or group of people cannot influence the market in the long term. Financial markets record hundreds of thousands and currently hundreds of millions of transactions per day. Over the course of a year, this adds up to a sizable sum. In the long run it is impossible to control such a complicated and complex process

Second rule

The financial market discounts everything, so market indexes illustrate market sentiment. It is important to compare the situation of individual assets with the mood of the broad market, illustrated by market indexes.

In times of a boom, even companies with weaker foundations have a chance to grow. 

This also works in the opposite direction - companies with solid foundations can also lose in a bull market.

Third rule

The Dowa theory is not infallible and is certainly not a money-making machine like other theories. It must be used with due caution with the support of many additional analyses.

 

Dow’s theorems 

In addition to the above three principles, several theorems have also been characterized that relate directly to price movement in the financial market. These are:

• There are three types of movement in the market - the main, long-term trend lasts from less than a year even to several years. The medium-term trend, or correction of the main trend lasts from a few weeks to a few months. The short-term trend, on the other hand, can last from a few days to a maximum of a few weeks.

• A bull market is a period of intense declines in asset prices - it usually begins by testing new maxima with declining volume, the so-called distribution. In turn, the fall is accompanied by an increase in volume. Booms are caused by the outbreak of crises, economic slowdowns, bursting of speculative bubbles, etc. The range of share price declines from recent maxima is 20 to 50 percent. It usually lasts about a year, and the downward trend is disrupted by upward corrections.

• A bull market means a long-term upward trend - after a strong decline, asset prices become attractive to investors who are not afraid to enter the market. On the other hand, many investors may feel resistance to entering the stock market due to the situation of the stock market. The allocation process begins, and the boom lasts more than two years on average.

• Higher degree corrections in a bull market are treated as a decline or rise in a bull market - corrections last from a few weeks to a few months and are characterized by the abolition of the last movement between 33% and 66%.

Dow theory allows us to describe and characterize the seemingly random behaviour of the market. It can be said that it organizes the financial market by classifying it according to patterns that have been occurring for years. First we have an accumulation phase, the beginning of a bull market, a major trend phase, and finally a distribution and bull market phase. Once the cycle is over, the general pattern repeats itself.

In the following lessons, we will discuss more tools and theories that will help you perform technical analysis in cryptocurrency trading.