Star Theory: The Fundamentals Investors Need to Know to Analyze the Market Wisely

Dow Theory was developed in the 20th century and has become the foundation of technical analysis to this day. This theory is not just a financial tool but a bridge connecting price movements with deep investor psychology.

Understanding Dow Theory is an invaluable resource for modern investors, whether trading stocks, gold, crypto, or currency pairs, because its core principles can be applied across all markets.

Dow Theory: From Past to Present

The story of Dow Theory begins with Charles H. Dow, a student and founder of The Wall Street Journal, who, along with William Peter Hamilton, developed advanced ideas about reading price charts.

At that time, Dow’s articles in The Wall Street Journal encouraged investors to think that price fluctuations were not just numbers on paper but reflected the emotions and behaviors of market participants.

Today, Dow Theory still exerts a significant influence on how millions of investors analyze markets, making it a lasting and time-tested financial legacy.

The 3-Level Structure of Trends in Dow Theory

One key aspect that defines Dow Theory is dividing trends into three distinct levels, each with vastly different timeframes.

Primary Trend — The major long-term trend, which has the greatest impact on investment decisions. It lasts from 200 days up to 4 years. Long-term investors should prioritize this level.

Intermediate Trend — A medium-sized adjustment within the primary trend, lasting from 3 weeks to 3 months. Mid-term investors seeking opportunities may monitor this level.

Minor Trend — The most recent short-term price changes, not exceeding 3 weeks. Day traders often observe signals at this level.

Interestingly, these three levels do not operate independently but interact with each other. Smart investors look at all three simultaneously to get a complete picture.

Deep Principles of Dow Theory: Sustainable Foundations

Dow Theory is not just about observations; it rests on six fundamental principles:

Principle 1: The market discounts all information. Every company’s data, economic indicator, or popular sentiment is reflected in the price chart. Reading charts is like reading the market’s mind.

Principle 2: The market has three types of trends — uptrend, downtrend, and sideways — which are central to investment decisions.

Principle 3: In an uptrend, prices create higher highs and higher lows. Conversely, in a downtrend, they form lower lows and lower highs. These are the language of the charts.

Principle 4: Volume must confirm the trend. When prices rise, volume should increase; when prices fall, volume should also increase. This is the most important confirmation.

Principle 5: Different indices should confirm each other. Dow originally used the Dow Jones Industrial Average and the Dow Jones Transportation Average to verify that the entire market moves in the same direction.

Principle 6: Trends persist until clear signals indicate a reversal. Not based on a single or a couple of movements but on sustained signals.

Trend Reversal Signals: Double Bottom and Double Top According to Dow

Once investors understand the basic trends, the next step is recognizing reversal signals. Double Bottom and Double Top are the most important patterns.

Double Bottom — Usually appears after a significant decline, where prices hit a low, rebound, then decline again but not below the previous low. Afterward, prices tend to rise again. This pattern resembles a “W” and indicates a potential beginning of an uptrend.

Double Top — The opposite pattern, where prices reach a high, pull back, then attempt to rise again but fail to surpass the previous high. Resembling an “M,” it signals a possible start of a downtrend.

These signals act as early warnings from the chart, indicating that the current trend is weakening and a new trend may be emerging.

What Investors Should Know: Advantages and Limitations of Dow Theory

Every theory has strengths and weaknesses, and Dow Theory is no exception.

Strengths: It provides clear, easy-to-read trend signals without complex mathematics and can be applied across all markets. When volume is considered, it helps confirm trend strength.

Limitations: It can lead to delayed decisions; by the time signals are clear, some opportunities may have passed. Also, Dow Theory does not account for company fundamentals or major news events that can cause sudden market shifts.

Smart investors often combine Dow Theory with other tools to get a more comprehensive view.

Applying Dow Theory to CFD Trading in Practice

Theories are only valuable if applied. The beauty of Dow Theory is that it can be used with CFD (Contract for Difference) strategies.

When analyzing stock or commodity prices based on Dow principles and identifying a clear uptrend supported by volume, traders might place a buy order to profit from upward movement.

Conversely, if signals indicate a completed downtrend with volume confirming the move, traders can place a sell order to profit from the decline.

For example, if gold charts show higher highs and higher lows with increasing volume, traders can confidently plan entries at suitable prices, set take profit levels above resistance, and stop-losses below support.

Summary: Dow Theory in Modern Investing

Although over 100 years old, Dow Theory remains an effective tool. By understanding and practicing the recognition of primary, intermediate, and short-term trends, as well as reversal signals, investors can better read the market.

Understanding Dow Theory does not guarantee success but provides more informed decision-making, reducing reliance on guesswork.

For beginners, opening a demo account with Mitrade or other platforms allows practicing Dow Theory with virtual funds, trying different strategies, and gradually adapting to your trading style.