Star Theory in Technical Analysis: A Main Approach for Traders

Dow Theory has been widely accepted in trading and market analysis circles for over a century. It is one of the most fundamental principles of technical analysis and is just as important as analyzing company fundamentals and economic indicators. This article will explore the core concepts of Dow Theory and how to apply them in trading various commodities.

Roots of Dow Theory: History and Origins

The basic ideas of Dow Theory were developed by Charles H. Dow and William Peter Hamilton in the early 20th century through various articles in The Wall Street Journal. This theory was designed to help investors understand the behavior of stock markets, commodity trading markets, and long-term price trends.

What is Dow Theory: Meaning and Basic Concepts

Dow Theory studies technical factors by considering the movements of commodity groups according to the economic cycle (sector rotation) and price fluctuations. The main idea is that market prices move in waves, similar to ocean waves. When the market is in an uptrend, the upward movements tend to last longer than the downward movements, and vice versa. In a downtrend, the decline phases are longer than the rise phases.

Three Levels of Trends

Dow Theory divides price trends into 3 types based on duration, each with its own characteristics:

Primary Trend - Long-term Main Trend
A large trend extending from 200 days to several years. Often, this trend can last 4 years or more, reflecting the overall direction of the market in the long run.

Intermediate Trend - Medium-term Trend
A trend lasting from 3 weeks to 3 months. Similar to the primary trend but on a shorter time scale. It acts as a correction within the main trend.

Minor Trend - Short-term Fluctuation
A short-term trend not exceeding 3 weeks, reflecting daily movements and short-term price volatility.

Movement Characteristics in Each Trend

Investors using Dow Theory need to understand the distinctive features of each trend:

Uptrend - Bullish Trend
The chart creates new highs higher than previous highs (Higher High - HH) and new lows higher than previous lows (Higher Low - HL), clearly indicating an uptrend.

Downtrend - Bearish Trend
Occurs oppositely; the chart creates new lows lower than previous lows (Lower Low - LL) and new highs lower than previous highs (Lower High - LH).

Sideways - Range-bound Trend
Prices fluctuate between HH, HL, LH, LL without a clear direction. The main trend cannot be identified.

Six Fundamental Principles of Dow Theory

Proper application of Dow Theory depends on understanding these 6 principles:

Principle 1: The Market Discounts All Information
All news and information about commodities, whether profit forecasts, competition status, or other factors, are already reflected in the price.

Principle 2: Types of Trends
Price trends are categorized into three types - primary, secondary, and minor - occurring simultaneously over different time frames.

Principle 3: The Three Phases of Trends
Every trend consists of three phases: (Accumulation), (Public Participation), and (Distribution).

• Accumulation Phase: The initial phase of an uptrend. Prices are not yet clear. Fundamental investors start accumulating at low prices, but chart traders avoid entering because the trend is not yet confirmed.

• Public Participation Phase: Prices rise clearly with increased trading volume. The commodity becomes widely discussed. It’s a golden opportunity for short-term traders because the uptrend is evident, and the time to find entry points is short.

• Distribution Phase: The final phase of the trend. Prices rise rapidly and are widely talked about. Good news spreads, small investors buy in, while large investors start selling to realize profits. Trading during this phase is risky; discipline and stop-loss are essential.

Principle 4: Confirmation from Multiple Indicators
In Dow Theory, Charles Dow used the Dow Jones Industrial Average and the Dow Jones Transportation Average to confirm trends. If one indicator shows an uptrend, the other should also confirm the same. Only then can the trend be considered genuine.

Principle 5: Volume Must Confirm the Trend
In an uptrend, trading volume (Volume) should increase with rising prices. In a downtrend, volume should increase as prices fall. This confirms the strength of the trend.

Principle 6: Trends Continue Until Clear Reversal Signals Appear
Prices will follow the trend until there is clear evidence of a change. For example, if gold has been rising but recently shows heavy selling for 3 consecutive days, failing to reach new highs but making lower lows, this indicates the uptrend has ended and a downtrend may begin.

Double Bottom and Double Top Patterns

Special patterns help traders identify trend reversals more effectively:

Double Bottom - Two Low Points
The chart shows a reversal from a downtrend to an uptrend. It occurs after a market decline, creating a strong support zone. It resembles a “W” shape, with two lows slightly different. It signals the market is preparing to rise.

Double Top - Two High Points
Indicates a reversal from an uptrend to a downtrend. It occurs after a market rise, encountering strong resistance. It resembles an “M” shape, with two highs slightly different. It signals the market is preparing to fall.

Advantages and Limitations of Dow Theory

Strengths:

• Solid fundamentals: Dow Theory has stable and clear principles, making it easy to understand and effectively apply.
• Market direction identification: Helps systematically classify market trends, aiding traders in planning.
• Emphasis on volume: Highlights the importance of trading volume in confirming genuine trends.
• No need for economic data: Can be used even when economic information is unavailable.

Weaknesses:

• Signal lag: Confirmation is required, which can delay trend detection. Often, prices move before confirmation signals appear.
• Ignores fundamentals: Does not consider company or market fundamentals, risking missing key supporting factors.

Applying Dow Theory in Trading

By analyzing according to Dow Theory, investors can clearly identify current trends and probable future price directions.

In an uptrend (Uptrend), such as gold showing Higher Highs and Higher Lows, traders can:

• Place Buy orders, believing the uptrend will continue.
• Choose appropriate lot sizes.
• Set leverage according to risk tolerance.
• Clearly define entry points, profit targets, and stop-loss levels.

In a downtrend, traders can opt for Sell orders to profit from falling prices.

Summary

Dow Theory is a valuable fundamental analysis tool that helps understand market behavior by emphasizing long-term trends, trading volume, and price movement characteristics. Practicing and understanding Dow Theory will enhance technical analysis skills and enable traders to plan more effective trades, combined with prudent money management and emotionless decision-making.