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| Dow Theory's Emotional Reactions in Trading |
🙋♂️Hello, respectful readers. ✍In this article, we will examine
the basic principles of the "Dow Theory", a powerful method of
analysis in financial markets. The Dow Theory has a long history in the field
of technical analysis. Used to understand trends and turns in the market, this
method has gained wide acceptance among investors and traders and has formed
the basis for other analysis techniques. In this article, we will cover the
basics and main principles of the Dow Theory, explaining how it works and how
it evaluates the markets. We will also review the relevance of this theory
today and how it contributes to understanding market fluctuations and making
more informed investment decisions. Let's get started.
📆The History of Dow Theory (Its Inception and Formation)
The Dow Theory is considered a critical turning point in the
early 1900s when the foundations of technical analysis were laid. Charles Dow
and Edward D. Jones played a significant role by gathering hard-to-reach
information from the market through their company and writing articles and
analyses for 📰the Wall Street Journal. Charles Dow shared his views on the
market in his column in the Wall Street Journal, and over time, these articles
evolved into the synthesis that formed the basis of the Dow Theory. The Dow
Theory did not originate as a formal theory. After Charles Dow's death in 1902,
his thoughts were brought together by William Hamilton and other editors and
named as the Dow Theory.
The birth of the Dow Theory was a necessary step in better
understanding market behavior and trends. Charles Dow's journey, starting with
his arrival in New York and finding a job on Wall Street, followed by
co-founding Dow Jones & Company with Edward D. Jones, marked the period
when the foundations of technical analysis were laid. By collecting market news
and developments and preparing articles for The Wall Street Journal, Dow and
Jones made an indispensable contribution to Charles Dow, often referred to as
the 'father of technical analysis,' did not actually write 📙a book on this
theory. However, the Dow Theory is based on the articles he wrote for The Wall
Street Journal between 1900 and 1902, which were later compiled and published
by Hamilton and Rhea after his death. William Hamilton is considered the person
who truly developed the Dow Theory by compiling Charles Dow's ideas. Along with
Robert Rhea's book titled 'The Dow Theory' in 1932, the Dow Theory was firmly
established on its modern foundations. The Dow Theory has been a valuable
analytical method used from the past to the present and has formed the basis
for other analytical methods. It continues to be a valuable tool for market
participants.the newspaper's launch.
❓ Where is Dow Theory used?
The Dow Theory is widely recognized as a prominent and
effective analysis method in the financial world. This theory can be applied
efficiently in various 📊financial markets, including stocks, commodities,
currencies, and cryptocurrencies, relying on historical price data. At its
core, the Dow Theory revolves around price movements and technical analysis,
providing investors with a valuable tool in these diverse markets. The primary
objective of the theory is to identify the market's direction and determine the
trends forming in the stock market. By disregarding short-term price
fluctuations, the main goal is to capture the existing trend in the market.
This approach enables investors to balance their cash or stock positions
according to the signals given by the trend, leading to a better understanding
of potential investment opportunities and risks, and the development of
appropriate strategies. By focusing on the long-term movements of the stock
market, the Dow Theory offers a perspective that is free from emotional
fluctuations and short-term noise in identifying market trends. 💪The strength of
the Dow Theory is its ability to utilize all types of data from the markets.
Charts, moving averages, volume analysis and other technical analysis tools
help traders examine past price movements and identify potential future trends.
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| The 6 Core Principles of Dow Theory |
❓ What are the Main Principles of Dow Theory?
The Dow Theory includes 6(six) basic principles, which are
essential for understanding market movements from a Dow Theory perspective. The
principles of Dow Theory are as follows:
- 1. Market reflects everything
- 2. There are 3 types of Trends in the Markets
- 3. Primary Trends consist of 3 Phases
- 4. Indexes must confirm each other
- 5. Trading Volume should confirm the Trend
- 6. Trends continue until reversal is confirmed.
1️⃣ Market reflects everything:
The Dow Theory, a prominent and effective analysis method in
financial markets, believes that prices in the market reflect all available
information and emotions. In other words, market developments, investor
expectations, and risk factors are already reflected in prices, making prices
the ultimate and conclusive data at the end of the day. According to this
theory, the current state of the market or the value of a financial asset
includes all instant or potential news and sentiments about that asset. It is
believed that news and information influence other investors' decisions and determine
price movements. Particularly, it is expected that positive or negative news
will impact prices. It is assumed that the information currently available in
the market is already priced in, and as soon as new information becomes known,
it will be reflected in prices. This mechanism ensures the efficient
functioning of an effective market.
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| Reflection of news and events on the market |
The Dow Theory embraces the idea that information and news are priced into the market as one of the fundamental assumptions of technical analysis. However, it is important not just whether everyone knows this information, but rather that what is known has already been reflected in prices, and what is unknown will be reflected when it becomes known. It is believed that one can understand what is happening in the market through the averages of market indexes. However, it should also be noted that verified information may not always produce the expected reaction. For instance, a piece of news expected to be positive might lead to an opposite price response. Moreover, unexpected and unpredictable events, 🌋such as natural disasters, political developments, or terrorism, can also be exceptions and swiftly impact the market, causing price changes. As a result, the Dow Theory offers a perspective that prices in the markets reflect all information and emotions in a complex manner. This approach helps us make informed investment decisions by evaluating information and news while considering the constantly changing and unpredictable nature of the market.
The Dow Theory has a significant impact in financial
markets, and according to this theory, market trends are divided into three
different categories: Primary trend, Secondary trend, and Tertiary trend.
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| Dow Theory's Trend Classification |
🔵 The Primary trend represents the longest-lasting trend
in the market. Lasting for over a year, this trend can represent either bull or
bear markets. Within the Primary trend, there are Secondary trends that occur
over several weeks to a few months. These Secondary trends are short-term
retracements or advances that move in the opposite direction of the Primary
trend.
🟢 Secondary trends can last from a few weeks to a few
months and are often seen as reaction trends that retrace about one-third to
two-thirds of the preceding move. Also known as reactions to the Primary trend,
these Secondary trends are a part of revealing the clear direction of the
Primary trend.
🔴 Tertiary trends are the shortest in duration and
occur within the Secondary trends. Lasting only a few days, these price
movements are considered insignificant according to the Dow Theory and may be
susceptible to manipulation.
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| The structure of rising and falling Trends |
The Dow Theory holds a fundamental basis in identifying
market trends. The formation of higher highs and higher lows in price movements
constitutes one of its key principles. If each successive trough and peak in
price forms above the previous troughs and peaks, it indicates the presence of
an uptrend. This means that prices are in an upward trajectory, presenting
buying opportunities. On the other hand, if the troughs and peaks in price form
below the previous troughs and peaks, it indicates a downtrend. This signifies
that selling pressure persists on prices, and it may be a signal to consider
selling positions. The Dow Theory analyzes prices based on closing prices and
disregards intraday price movements. As a result, the closing prices have a
significant impact on determining the primary trend, secondary trend, and
tertiary trends. The closing prices of an index are considered a reflection of
the market and are utilized in identifying trends.
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Stages of the Uptrend
(Bull Market) |
Stages of the Downtrend
(Bear Market) |
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Accumulation (Recovery)
Phase |
Distribution (Surplus) Phase |
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Participation (Rising) Phase |
Panic (Collapse) Phase |
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Excess (Exaggeration) Phase |
Despair Phase |
🐮 The stages of an uptrend (Bull Market):
1.The first stage of the uptrend, called the Accumulation
Phase, represents a period in the market where the prices of financial
assets have reached their lowest levels, and the downtrend comes to an end.
During this phase, the impact of negative news diminishes or becomes exhausted.
Positive news and signals become more frequent, indicating a tendency for the
market to start rising. In the Accumulation Phase, successful investors make
their purchases and then adopt a wait-and-see approach. Investors considering
short-term positions wait for a correction or pullback, while long-term
investors do not plan to sell their assets during the rising trend period.
Since this stage occurs immediately after a bear market, prices are still at
low levels. During this period, investor interest increases, and assets
gradually start to accumulate.
2.The Participation Phase is a lively and exciting
period in the market. Prices rise rapidly, and investors actively participate
in the market to seize increasing opportunities. This phase lasts longer
compared to the previous accumulation period and involves a broader range of
investors in the market. During this period, increases in companies'
profitability are anticipated, growth targets are raised, and positive
forecasts are made for stock prices. These positive expectations lead to significant
upward movements in the market. In the Participation Phase, a much larger
number of investors take long positions compared to the accumulation period.
This stage is the longest among the three stages of the uptrend and covers the
widest range of prices.
3. The Excess Phase signals that bull markets are
approaching their end. Promising economic expectations and high corporate
profits supported by the media create a belief that the trend will move even
higher or at least continue to rise. High earnings attract everyone's
attention, regardless of their relevance, and trading volumes reach record
levels. However, at this stage, the situation is characterized by excessive
speculation, and prices start to deviate from their true values, similar to the
initial phase of a bear market. Prices become exaggerated, and during this
excess phase, a smaller but well-capitalized group of investors begins to sell
a significant portion of their assets. This situation, often observed as the
bull market nears its end and the bear market begins, does not offer a
favorable opportunity even for many small investors who buy the product at its
highest level.
Evolution of Trends as per Dow Theory
🐻 The stages of a downtrend (Bear Market):
1.The first stage of the downtrend, known as the Distribution
Phase, is a period in the financial markets where the prices of an asset
start to decline from high levels, and investors begin to sell their holdings.
During this phase, those who believe the uptrend is coming to an end realize
that asset prices will no longer rise significantly and start to liquidate
their current positions. In the Distribution Phase, trading volumes in the
market can still be high, and prices follow an uncertain course. Some investors
may perceive declines as short-term buying opportunities, but later realize
that this notion is misleading. The bear market advances quietly and deeply
during this stage, and prices gradually begin to decline. Demand decreases
while supply increases, indicating the beginning of the downtrend. The
Distribution Phase signals the start of the downtrend and indicates that the
market is beginning to follow a negative trajectory.
2. The second stage of the downtrend, known as the Collapse
Phase, bewilders the market. All prices rapidly move downward, and
expectations are quickly revised to reflect a decline. This stage is both
longer and encompasses wider price ranges compared to the other two phases of
the downtrend. With the participation of trend followers, prices deepen
further, and the downward momentum increases. Economic indicators and corporate
earnings also paint a negative picture during this stage. Uncertainty prevails
in the market, and there is apprehension in the face of collapsing prices, with
little hope of a recovery. Any positive news or signals prove insufficient to
halt the overall downward trend. During this stage of the downtrend, everyone
tends to develop protection strategies. Confidence in stocks decreases, while
there is an increase in the inclination towards safe-haven assets.
3. In the Despair Phase, the market is filled with
uncertainty, and a sense of hopelessness prevails about the future. Prices
continue to fall, and stocks and other assets reach low values. During this
period, there is uncertainty about when the market decline will come to an end,
and everyone is anxiously waiting. However, at this stage, some investors start
to believe that the downturn is nearing its end and begin to make purchases.
With these purchases, prices start to recover from the bottoms, and the market
enters a period of improvement. Despair slowly gives way to optimism, and hopes
for the beginning of a new uptrend increase.
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| The Stages of Uptrend in EUR/USD pair |
The principle of confirmation between indexes states that
for a new trend to form, different indexes in various markets need to confirm
each other. Charles Dow illustrated this principle by using the example of the
relationship between the Dow Jones Transportation Average and the Dow Jones
Industrial Average. According to this principle, a strong condition in the 🚛transportation market usually implies that the 🏭industrial market is also in
good shape. If one index is rising while another is falling, it wouldn't be
accurate to conclude that a rising trend has emerged based solely on the ascent
of one index. A rising trend becomes stronger and more sustainable when indexes
in different markets confirm each other's movements. If different indexes are
moving in different directions, it may indicate uncertainty and indecisiveness
in the market.
According to the Dow Theory, volume plays a critical
role during trend movements. If prices are moving in the direction of the
primary trend, volume should also increase. On the other hand, if prices are
moving against the primary trend, volume should decrease. For instance, in a
bull market where prices are in an uptrend, the rising candles should be
supported by high volume, while the falling candles should have lower volume.
If during the uptrend, the volume decreases gradually, or during the downtrend,
there is high volume, this may indicate that the trend is weakening and could
potentially reverse.
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| Trend relationship with trading Volume |
It is generally accepted that as long as the trend is valid,
it will continue until a confirmation of a reversal is obtained. Charles Dow
emphasized the significance of turning points, as he previously mentioned in
the stages of the primary trend. For instance, an uptrend can end when the
previous peak is not surpassed, and then a reaction occurs with prices falling
below the previous dip level. Similarly, a downtrend can come to an end when
prices fail to fall below the previous dip level, and then a reaction takes
prices higher, surpassing the previous peak. However, if such situations do not
occur, it is assumed that the current trend will continue.
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| Confirmation of Trend Reversals |