Technical analysis: the Dow theory

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[vc_row][vc_column][vc_column_text]At the beginning of the century, the Dow theory laid the foundations for what would become modern technical analysis. The latter was formulated by Charles Dow, also known to have provided the fundamentals for the creation of the Dow Jones. There are three main theories of Dow theory. 

* The price above all 

* Price movements are not totally random

* The What > Why

>> The price above all. 

Purely technical analysts rely on a single theory: all the information is in the price. This means that the current market price fully reflects all information. Thus, only the asset price should be used to anticipate future movements. When you think about it, the price of an asset reflects the sum of the knowledge of all the players: traders, investors, analysts, fund managers, etc. In short, the current price of an asset corresponds to a price set by a fairly impressive group of people with various skills/sources of information. The purpose of technical analysis is to interpret the information given by the asset price to anticipate the future. This requires different tools, indicators, analysis techniques that we will detail in another article.

>> Price movements are not totally random.

Prices don’t do what they want. In general, and most technical analysts will confirm it to you: prices follow trends. I insist on the “in general” because, as with everything else, there are exceptions: in particular during trend reversals. There’s just one thing to remember: technical analysts rely on trends to trade. If prices were always in purely random movements, it would be extremely difficult to set up a trading plan.

>> What > Why. 

A technical analyst knows the price of everything, but the value of nothing. There is nothing more to add. The most common mistake for beginners is their inability to distinguish between trading and investing. They even manage to mix their trading capital with that for long-term investments. Some people even remove a stop loss from a losing position because “it will go up, it’s an asset [insert a justification that is based on a belief]”. On this subject, I wrote an article about technical analysis where I mention the biggest traps in which 90% of beginners fall. To read it, it’s this way: 

To come back to the last point, a technical analyst is only concerned with two things: 

What is the current price? What is the history of the price movement?

Remember that price is the final result of the battle between supply and demand for a given asset/value/good. Analysts who rely solely on the fundamental (which can be very interesting for long-term investments) will ask themselves the following questions: “Why is the price what it is? Technical analysts have a more direct approach, they remove the “why” part – considered too broad and focus on what: what is the current price and what is the history of the price movement.  To the question: “why the price went up” – a technical analyst will simply answer that there were more buyers than sellers. It is the law of supply and demand. 

I hope you have learned something new,

Nico, 4C-trading analyst.

 


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2 thoughts on “Technical analysis: the Dow theory”

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