Dow Theory (part two)

Let us look at four other postulates that are at the basis of Dow’s theory, on which the technical analysis of financial markets is based.

The market discounts all available information

One of the fundamental postulates of Dow’s theory states that the market reflects all available information, past, present and future, and encapsulates it in prices. Experts are divided on whether the information contained in the price system is all of it, or whether there is private information that is excluded from prices. From this point of view, Dow’s theory is linked to the efficient markets theory developed by Eugene Fama. An efficiency that, as is known, can be assumed in the three forms: strong, semi-strong and weak, based on the assumptions made on how available information is captured by market prices.

The market indices must confirm each other

The transition from a bullish to a bearish market (or vice versa) is only possible when more than one market index shows similar trends. The main trends, upward or downward, represent the general direction of all markets reflecting the same economic conditions. For example, if two currency pairs in which the US dollar is quoted or is a counter-currency in one of the two pairs, are in conflict, it is likely that there is no clear trend reversal. For a trend reversal to exist, these conflicts must be resolved before.

The volume must confirm the trend

The volume increases when prices move in the direction of the trend and decreases when prices move in the opposite direction. The endogenous causality between price and volume (“what causes what”) could be debated at length, but the empirical evidence on this topic is not unambiguous and therefore it is necessary to move the debate more to an academic field rather than on a practical one. However, some useful examples can be given. If a bullish trend shows strength when the volume increases, one can assume that traders are betting on the continuation of the bullish push. However, if the volume is weak on the bullish movement, it means that the purchase of a currency is shrinking. This means that if buyers become sellers, the market will not continue its bullish trend.

The trend reverses only with the evidence

According to the principles of technical analysis, the reversal of market trends only takes place in the presence of concrete evidence. For example, if the EURUSD pair is moving downwards but unemployment in the eurozone is falling, the downward movement cannot be called a trend reversal, at least according to the principles of the technical analysis.

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