A set of general principles called the Dow Theory, can help you take action on different price action data sets in the market. Based on the writings of Charles Dow, who was one of the founders of The Wall Street Journal and the Dow Jones & Company, it is a foundational concept in technical analysis used to analyse and interpret movements in the stock market.
The Price Discounts Everything
This principle states that all known information about a stock, sector, or the overall market, including fundamental, technical, psychological, and external factors, is already reflected in the price.
The Market Has Three Trends
The Dow Theory identifies three main trends in the market: primary, secondary/intermediate, and minor trends or daily fluctuation. The primary trend reflects the overall direction of the market and can last for months or even years. Secondary trends are corrections within the primary trend, lasting from a few weeks to a few months. Minor trends are short-term fluctuations that occur within the secondary trends.
Trends Have Three Phases
These phases represent the stages of investor sentiment and market behavior as the trend unfolds.
In this phase, informed investors start to take positions in the market and the general public may not be actively participating. The trend might not be evident to most market participants.
As the trend gains momentum, more participants become aware of it. Prices start to move more decisively in the direction of the trend. During this phase, which tends to be the longest one, the trend becomes more apparent, and more traders and investors begin to participate.
In this phase, the early investors, who bought during the accumulation phase, start to sell and begin to take profits. This phase often marks the transition from the current trend to a potential reversal or the beginning of a new trend in the opposite direction.
The Averages Must Confirm Each Other
The Dow Theory suggests that a trend must be confirmed by a correlated pair. In other words, the one currency pair confirms the movement of a correlated currency pair. If one average reaches a new high or low, the other should ideally follow suit within a reasonable period to confirm the direction of the trend.
The Volume Must Confirm The Trend
Volume should confirm the direction of the trend. For example, during an uptrend, increasing volume should accompany upward price movements, indicating strong buying interest.
A Trend Is Assumed To Be In Effect Until It Has Given A Definite Signal That It Has Reversed
This principle implies that trends persist until there is clear evidence of a reversal. Traders and investors typically look for specific signals or patterns to identify potential trend reversals and should continue trading in the general direction of the trend until the trend reversal.
The above 6 principles of the Dow Theory serve as the foundation for analyzing market trends and making informed trading decisions. Traders can incorporate these principles along with other technical and fundamental analysis tools to gain insights into market dynamics and trends.
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