Technical Analysis Basics: Dow Theory

Dow Theory is a theory on price movements that provides a basis for technical analysis. The theory was derived from 255 Wall Street Journal editorials written by

Charles H. Dow (1851–1902), journalist, first editor of the Wall Street Journal and co-founder of Dow Jones and Company.

Many technical analysts consider Dow Theory's definition of a trend and its insistence on studying price action as the main premises of modern technical analysis.

What does the Dow Theory tell us?

1) The market discounts everything

The actual price is the true price. For example, when the EUR/USD is quoted at 1.2501/03 than that is a fair value for the EUR/USD pair. Dow assumes that all information about the EUR/USD has already been taken into account and is reflected by the current market price.

2) The market is comprised of three trends

Dow defined an uptrend (trend 1) 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.

Downtrends (trend 2) occur when markets make lower lows and lower highs. It is this concept of Dow Theory that provides the basis of technical analysis' definition of a price trend.

Dow described what he saw as a recurring theme in the market: that prices would move sharply in one direction, recede briefly in the opposite direction, and then continue in their original direction (trend 3).

3) Trends have three phases

Major market trends are build up of three phases: an accumulation phase, a public participation phase, and a distribution phase represented by a primary trend, a secondary trend and several minor trends.

I. Primary trend- usually lasts more than one year and may last for several years
These movements are typically referred to as bull and bear markets.

II. Secondary trend - represents a temporary (corrective ) change in price within a primary trend, that may take weeks or few month.

III. Minor trends - are short-term movements lasting from a few days to several weeks but are of little significance.

Trends have three phases

Main point to remember about the Dow Theory:

There are three type of trends in the market, a primary trend, a secondary trend and minor trends. That's it!