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What is the Dow Theory?

As the basis of technical analysis of financial markets, the Dow Theory is something most analysts, investors and traders pay attention to. The Dow Theory doesn’t impact the forex market directly, but ripple effects will be sent through the system and it is wise to fully understand what caused the waves in order to trade profitably.

The Dow Theory only is concerned with closing prices, rather than intraday movements within the markets. This helps traders filter out the ‘white noise’ and allows them to focus only on the relevant price movements.

Six basic tenets of Dow Theory

One: The price (average) discounts everything

Every known or unknown component that may perhaps affect both demand and supply is reflected in the market price. For example, all major geo-political events, trade war, domestic policies, elections, GDP growth, changes in interest rates, earning projections or expectations are already reflected in the markets through the price. However natural calamities like drought, cyclone, flood or earthquake can’t be reflected. 

Two: There are three primary kinds of market trends

Dow Theory highlights that primary trends tend to last for one year or more. They dictate whether a market is bullish (upward moving) or a bearish (downward moving). Secondary trends are the corrective moves within a primary trend. They typically last between three weeks and three months, and lead to corrections (a drop in prices) in a bull market and rallies (upticks in prices) in a bear market. Finally, there are minor trends that only last a matter of days and which are largely "market noise", in other words, unpredictable short-term fluctuations in stock prices.

Three: Primary trends have three phases

The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterised