DavidWaring

In the last lesson on technical analysis we talked a bit about the different ways that traders analyze the markets. In this lesson we will look at the history of technical analysis and something known as Dow Theory.

Most consider the father of technical analysis to be Charles Dow, the founder of Dow Jones and Company which publishes the Wall Street Journal. Around 1900 he wrote a series of papers which looked at the way prices of the Dow Jones Industrial Average and the Dow Jones Transportation Index moved. After analyzing the Indexes he outlined his belief that markets tend to move in similar ways over time. These papers, which were expanded on by other traders in the years that followed, became known as “Dow Theory”.

Although Dow Theory was written over 100 years ago most of its points are still relevant today. Dow focused on stock indexes in his writings but the basic principles are relevant to any market.

Dow Theory is broken down into 6 basic tenets. In this lesson we are going to take a look at the first 3 and then finish up our conversation of Dow Theory in the next lesson by looking at the last three.

The first tenet of Dow Theory is that The Markets Have 3 Trends.

• Up Trends which are defined as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows.
• Down Trends which are defined as when the market makes successive lower lows and lower highs.
• Corrections which are defined as a move after the market makes a move sharply in one direction where the market recedes in the opposite direction before continuing in its original direction.

To help better understand each trend lets look at an example of each:


The second tenet of Dow Theory is that Trends Have 3 Phases:

• The accumulation phase which is when the “expert” traders are actively taking positions which are against the majority of people in the market. Price does not change much during this phase as the “experts” are in the minority so they are not a large enough group to move the market.
• The public participation phase which is when the public at large catches on to what the “experts” know and begin to trade in the same direction. Rapid price change can occur during this phase as everyone piles onto one side of a trade.
• The Excess Phase where rampant speculation occurs and the “smart money” starts to exit their positions.

Here you can start to see how the psychology of investors and traders comes into play an important concept which we will delver deeper into in later lessons.

One of the best examples which shows these three phases occurring in an uptrend that most people are familiar with is the run-up up the NASDAQ into 2000:


The third tenet of Dow Theory is that The Markets Discount All News, meaning that once news is released it is quickly reflected in the price of an asset. On this point Dow Theory is in line with the efficient market hypothesis which states that:

“the efficient market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.”

Source: Wikipedia

This concept that the markets discount all news is one that is sited in arguments in favor of using technical analysis as a tool to profit from the markets as if it is true that markets already discount all fundamental factors then the only way to beat the market would be through technical analysis.

So now you should have a good understanding of the first three tenets of Dow Theory including the different types of trends, the different phases of trends, and Dow’s concept that the price of an asset already reflects all known news. In our next lesson on Dow theory we are going to look at the second three tenents.

As always if you have any questions or comments please feel free to leave them in the comments sections below, and have a great day!

Other Links to Help You Learn About Dow Theory

Linda Bradford Raschke on Dow Theory
Dow Theory - Wikipedia, the free encyclopedia
The History of the Dow Theory
http://www.thedowtheory.com/Description&results.html

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bolhoso

In Trading for a Living (from Alexander Elder), the chapter 36 "Time" and chapter 43 "Triple Screen trading system" are good additional reading. The only problem is that he talks about technical indicators, which haven't been showed until now.
The first of them, in the subsection "The factor of five", he enphasize the importance of wider timeframes; and in the chapter 43, it's a practical approch on using different timeframes to analyse a security.

Best whishes,

Lucas.

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harirk

What are the various phases in a down trend?

- Hari

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David Waring

Hi Hari,

Glad to hear from you and good question.

The three phases of primary downtrend are similar to the three phases of uptrends but two of the phases are named a bit differently.

The first part of a downtrend is referred to as the "distribution period". This is the period at the top of the uptrend when the "smart money" starts to sell out of the positions in anticipation of the trend ending. The period in the market after the market begins to sell off and the downtrend accelerates, is exactly the same concept as the "public participation" phase in the uptrend and is also called the "public participation" phase in a downtrend. This is when everyone is wize that the market selling off and jumping on board by either dumping their long positions or entering into new short positions. The part of the move that occurs near the bottom when everyone is panicking thinking the market is just going to keep going lower and lower, and excellerating the move by irrationally dumping long positions or entering into new short positions is referred to as the "panic" phase.

Hope that helps. If there are any other questions or comments on this one please feel free to post below.

Best Regards,
Dave

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Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

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themillionaire08

I always read the phrase "higher high & lower low" when speaking about price movement, what is that mean?

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David Waring

Hi Themillionaire08,

Glad to hear from you.

What this means is that in an uptrend when the market moves up the point at which is stops moving higher and begins to pull back should be higher than the last point where the market made a high and then started to pull back.

Similarly as the market pulls back the low that the market eventually trades higher from (continuing the uptrend) should be higher than the last low. Here is a picture of what I am talking about:

Higher Highs and Higher Lows


Hope that helps. If there are any other questions or comments on this one please feel free to post as always.

Best Regards,
Dave

__________________
InformedTrades University | IT Shopping Guide | Site Map


Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Thank

 

themillionaire08

Thanks Waring for the explanation

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irfan

Hey dave..

Thanks for the tutorial.. just wanted to ask what do you mean by "long position" and "short position" as you mentioned in one of your replies...

David Waring

Hi Irfan,

Glad to hear from you and thank you for the compliment.

"Going Long" is the same thing as buying to enter a position. (when you want to profit from the market going up)

"Going Short" is the same thing as selling to enter a position. (when you want to profit from the price going down)

Hope that helps. If there are any other questions or comments please feel free to post.

Best Regards,
Dave

__________________
InformedTrades University | IT Shopping Guide | Site Map


Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Thank

 

billal4assar

David,

please give me some trusted sites that can help me to know whts going on with oil market.... thanks

Thank