Dow Theory: The principles that every trader should know
The journalist and economist Charles Dow, who presented his theories of economic analysis in the Wall Street Journal, created stock market indices as a methodology and proposed six principles that became the basis of the technical analysis we know today.
“In 1882 Charles Dow and his partner Edward Jones founded the “Dow Jones and Company”. What is known today as technical analysis has its origins at that time because in this company Dow developed a series of theories that today many traders assimilate, even if they do not recognize their authorship. These theories were summarized in six principles that were applied to a totally innovative concept for the time: “The stock market averages” that today we know as Indices (S&P 500, NASDAQ 100, Dow Jones 30, IBEX 35 etc). As many know, these averages are the barometer of the stock market activity and in first world countries they reflect very well the health of their economies. In spite of this, Dow Jones’ contributions did not stop here, some recognized market figures, such as Richard Russell, qualified the contribution he made to the markets with Freud’s contribution to psychiatry and it is not for less since through the compilation of his articles in the Wall Street Journal traders have at their disposal the following six principles to understand the logic of price:
Prices discount everything
The price trend and the sum of the stock market operations reflect all the past information that investors have about an asset. This means that there is no need to keep an eye on the news or make very complex fundamental analyses, since the effect of these has already been taken into account in the movement of the price and although it is true that statistically markets cannot anticipate natural calamities or any other economic disaster, if they can quickly discount it in prices, within minutes of something of this magnitude happening.
The market has three trends
Many traders today usually work with a three-screen trading system because in one way or another they are aware that movements in the market can be analyzed in the Long, Medium and Short term. This idea is one of the principles of Dow, and allows us to take advantage of the corrections of a long-term trend in the medium and short term being aware that in each of these temporalities the trend works independently, even so favoring the long-term trend in the short term significantly amplifies the relationship between risk and profit as we assume the risk of the short term (which is less than the long term) expecting benefits from movements in the lake term.
The trends have three phases
The first phase is the accumulation or “Smart Money” that institutional investors make with privileged information, either because of the high investments that people with large volumes in the market make in research and development or because of some type of data filtering that of course are not accessible to the public. The strategy at this stage is to accumulate positions slowly so as not to attract too much attention.