By now, you have already come across the term ‘technical analysis.’ This is a method of predicting the price direction of an asset by analyzing past price and volume data. Technical analysis owes much of its origin to the Dow Theory that was formulated by Charles H. Dow. Here, you will learn more about the Dow Theory, its basic tenets and its applicability in market trading.
Binary Options Trading: The 6 Tenets of Dow Theory
Technical analysis entails forecasting the future of price movements by assessing the past behaviour of an asset and its corresponding price movement. Technical analysts use charts and other analysis tools to recognize patterns that may indicate the future price movment of any financial instrument.
History of the Dow Theory
Charles H. Dow formulated his Dow Theory in 1900. The theory sought to describe stock market behavior and how businesses could use the stock market to assess the performance of their respective industries.
Dow posited that the performance of the stock market is a reliable indication of the business conditions in any given economy. As such, by studying the stock market in its entirety, it would be possible to determine the direction of the market as well as that of individual stocks.
The Dow Theory facilitated the creation of the Dow Jones Rail Index, which is presently the Transportation Index, and the Dow Jones Industrial Index. These indexes were seen to reflect the performance of businesses in the respective industries i.e. the transport and industrial industries. These indexes are certainly not what they were when Dow formulated them over a century ago but most of the market indexes today still apply the Dow Theory.
The Basic Concepts of the Dow Theorya) The market discounts everything
The first concept of this theory is that all information, including past, present and future, affect the markets and this in turn impacts on the price of indexes and stocks. New events and information cause the marker to adjust accordingly and so do the prices of indexes and stocks.
b) The market has three trends
In technical analysis, a trend is the direction the market is moving. According to the Dow Theory, markets have primary, secondary and minor trends. A primary trend is the most significant and lasts for over a year. A secondary trend last between one and three months and it often moves against the primary trend. The minor trend typically has a shorter duration of less than a month and tends to follow the direction of the secondary trend.
c) Every primary trend has three phases
The primary trend has three phases in both bullish and bearish markets.In a bullish market, the first of these phases is the accumulation phase, which indicates the beginning of an uptrend. Advanced traders enter the markets during this phase. In a bearish market, the first phase is the distribution phase, which is the opposite of the accumulation phase.
In a bullish and bearish market, the second phase is the public participation phase where positive economic data and strong earnings eliminate negative sentiments. As such, more and more investors get into the market and cause stock prices to rise.
The last phase in a bullish market is the excess phase also known as the panic phase in a bearish market. Here investors begin to sell off their stocks to those traders who are entering the market.
d) Market indexes confirm each other
According to the Dow Theory, all major market indexes must confirm each other for a trend to be considered as being reliable. If one index indicates an upcoming downtrend, so should the other indexes. Otherwise, it would be difficult to make informed trade decisions if a trend is not reliably confirmed.
e) Volume confirms the trend
The theory uses price movement of stocks and indexes as the main trading signals. However, the theory asserts that volume can also be used as a secondary trade signal to confirm the signals issued by the price movement. In essence, when prices move in the same direction of the trend, volume should increase and vice versa.
f) A trend remains in effect until a reliable reversal occurs
The final aspect of the theory is that as long as there is no clear reversal, the prevailing trend remains in effect. This means that traders need to confirm that an actual and established reversal has occurred to avoid trading against the trend.
Today, many technical analysis tools use this Dow Theory as a basis for trading the market.Technical analysis tools allow you to determine the direction and performance of the market simply by looking at price movement of a company’s stock or an industry index. As a binary options trader it is important to learn how to use this market analysis method to improve your trading strategy.