What is the (Dow Theory)? How it works and its importance for investors

Dow Theory or ทฤษฎีดาว is considered one of the fundamental principles of technical analysis that is most important. Created over 100 years ago, it remains a tool used by investors worldwide to make investment decisions. The significance of Dow Theory is as important as studying a company’s fundamentals or economic indicators. Dow Theory can be applied to trading various commodities. This article will explain the principles of Dow Theory and how to apply them in investment in detail.

What is Dow Theory?

Dow Theory is an analysis of technical factors from the perspective of sector rotation (sector rotation) and studying stock price movements. This theory originated from an article in the Wall Street Journal written by Charles H. Dow, the founder of the Dow Jones Industrial Average.

History and Development of Dow Theory

Dow Theory was developed by Charles H. Dow and William Peter Hamilton in the early 20th century. It became a crucial foundation for analyzing market directions, especially in stock markets and various commodities. It consolidates core principles for analyzing price charts and forecasting future market movements.

How Dow Theory Works

The basic principle of Dow Theory compares the rise and fall of stock prices to ocean waves. During an uptrend, the length of the upward trend is clearly longer than the downward trend, and during a downtrend, the length of the downward trend exceeds the upward. This movement resembles waves rising and falling consistently.

The Importance of Dow Theory in Investment

Dow Theory is a model for stock trading using technical analysis and is one of the most important theories for investors focusing on technical analysis. Developed over decades, it covers not only price charts but also market behavior and investor psychology.

Main benefit of Dow Theory is enabling investors to follow major trends and profit from each cycle. When understanding and practicing Dow Theory, investors will know whether the market is in an uptrend (or downtrend), allowing them to plan and prepare for market situations in both short and long term. This understanding also helps reduce risks from incorrect predictions and potential losses.

The Three Main Trends of Dow Theory

Dow Theory divides price chart trends into 3 types based on time frames:

1. Primary Trend - Main Trend

Primary Trend or long-term trend is a major trend lasting from 200 days or about 1 year, sometimes up to 4 years. This type of trend determines the overall direction of the market in the long run.

2. Intermediate Trend - Secondary Trend

Intermediate Trend or medium-term trend is similar to the primary trend but differs in duration, typically lasting from 3 weeks to 3 months.

3. Minor Trend - Short-term Trend

Minor Trend or short-term trend is similar to the other two but with a shorter duration, usually less than 3 weeks.

All three trends are interconnected, and each can be of 3 types:

• Uptrend (Uptrend): The chart makes higher highs (Higher High = HH) and higher lows (Higher Low = HL) than before.
• Downtrend (Downtrend): New lows are lower than previous lows (Lower High = LH) and new lows are lower than previous lows ( Lower Low = LL).
• Sideways (Sideway): Prices fluctuate between HH, HL, LH, LL without a clear direction.

Six Key Principles of Dow Theory

Dow Theory is supported by 6 fundamental principles:

1. The market discounts all information

Dow Theory believes that all news about stocks, whether profit forecasts, competitive advantages, or other factors related to the company, are already reflected in the stock price.

2. Prices move in three trends

As previously explained, these are the primary, intermediate, and minor trends.

3. Each trend has three important phases

Phase 1: Accumulation (Accumulation Phase) The initial phase of a new upward movement. The trend is not yet clear. Fundamental investors start accumulating because prices are still low, while technical traders may ignore buying at this stage due to the unclear trend.

Phase 2: Public Participation (Major Uptrend Phase) Prices rise clearly with increased trading volume, and the asset begins to be widely discussed. This phase is suitable for short-term traders because the uptrend is evident.

Phase 3: Distribution (Distribution Phase) The final stage of the uptrend, where prices rise rapidly and are widely talked about. This is an opportunity for large investors to sell and take profits. Buying during this phase carries high risk.

4. Everything must be in harmony

Charles Dow used the Dow Jones Industrial Average and the Dow Jones Transportation Average to confirm each other’s trends. If one index begins an uptrend, the other must also begin an uptrend to confirm that the market is truly in an uptrend.

5. Volume must correlate with the trend

In an uptrend, trading volume (Volume) should increase with price, or in a downtrend, selling volume should increase. This confirms that the trend and volume are aligned.

6. The trend continues until clear signals indicate a change

Prices tend to continue their trend until there is a clear signal of reversal. For example, during an uptrend, if there are three consecutive days of heavy selling, and prices do not make new highs but make new lows, this indicates the uptrend has ended.

Double Bottom and Double Top Patterns

Double Bottom Formation (forms two lows)

Double Bottom is a chart pattern indicating a trend reversal from downtrend to uptrend. It often occurs when the market drops low and creates a strong support area, forming a “W” or “U” shape after the price hits lows twice, with the high point between the lows lower than the previous high. This signals the market may be ready to rise.

Double Top Formation (forms two highs)

Double Top indicates a trend reversal from uptrend to downtrend. It often occurs when the market reaches a high and creates a strong resistance area, forming an “M” shape with two peaks, where the low point between the peaks is higher than the previous low. This signals the market may be ready to fall.

Using Double Bottom and Double Top in analysis is a technique to forecast future price directions. However, no technique can predict the market with 100% accuracy, so skill and knowledge in technical analysis are essential.

Advantages and Disadvantages of Dow Theory

Every analysis system has strengths and weaknesses. Investors can adapt them to suit their investment style.

Advantages of Dow Theory 👍

Stable and easy to understand: Dow Theory has clear and straightforward principles, making it easy to grasp.

Effectively indicates market direction: Helps identify market trends, improving trading decisions.

Emphasizes trading volume: Highlights the role of volume in confirming trends.

Does not rely on economic data: Can be used even when economic data is unstable.

Disadvantages of Dow Theory 👎

Confirmation delay: The need for confirmation from the market causes delays in detecting trend changes. Sometimes, prices move rapidly before confirmation.

Ignores fundamental data: Focuses only on price and volume, potentially overlooking company or market fundamentals.

Trading Strategies Based on Dow Theory

Dow Theory describes the characteristics of different trends—uptrend, downtrend, and sideways—which provide opportunities for traders to choose trading methods based on market conditions.

The suitable trading style for Dow Theory is using CFDs (Contract for Difference) because they allow trading in both directions. If expecting an uptrend, use a Buy Order; if expecting a downtrend, use a Sell Order.

Example of Uptrend Trading:

From the chart, gold prices are moving in an uptrend with Higher Highs and Higher Lows. Traders can plan to:

• Place a BUY order
• Set an appropriate lot size
• Use leverage aligned with risk management
• Define entry points, take profit, and stop-loss levels

By analyzing prices according to Dow principles and understanding the current trend and probable movements, traders can plan their trades carefully. Proper money and risk management are essential.

Summary

Dow Theory is an effective and easy-to-understand technical analysis tool. Its principles are simple yet profound. When investors practice and deepen their understanding of Dow Theory, they can improve their technical analysis skills. Applying Dow Theory along with good money management strategies will help investors gain confidence in trading various assets, including stocks, commodities, or cryptocurrencies.