Dow theory for forex trading

Before you start learning technical analysis, you need to study the history and postulates on the basis of which it is built. 

After all, if you start studying such a broad area, a lot of questions arise that are related precisely to the foundations and foundation on which it is built.

The world first learned about the Dow theory thanks to the world-famous publication of the book “The ABC of Speculation in the Stock Market,” which was written by S. Nelson.

It is in it that for the first time you can come across the mention of such a term as “Dow theory”. The author of the book took as a basis articles that were written by Charles Dow in the Wall-Street-Journal, where the author shared his theoretical vision of the stock market.

The articles were published at the end of the 90s, but a couple of years later Charles died, and the world never saw his practical research. However, this did not stop Nelson from systematizing the acquired knowledge and formulating it as the Dow Theory, which became the foundation for the development of technical analysis.  

Like any theory in any scientific field, it is built on unshakable postulates. After reading them, you will immediately understand why the Dow theory is relevant to this day and can be used for trading on both the stock exchange and the forex market. Now let's get to the postulates:

1) The price takes everything into account.

Charles Dow argued that the price takes into account all factors that can affect the market; therefore, when you see a particular price for a stock, index, currency, you must understand that all economic indicators, statements by politicians and various natural disasters, catastrophes, terrorist attacks and disasters by it taken into account.

You will ask why? The fact is that we all buy or sell on the basis of some facts, some paying attention only to the statements of politicians, others looking at economic reports, and others relying on key psychological levels, but one way or another, in the aggregate, all factors influence the price because We, as market participants, move the price with our purchases and sales based on them.

2) Price movement is always subject to trends.

For quite a long time, it was believed that the price moves chaotically and unpredictably. However, Charles identified three types of trend, namely upward, downward and sideways. Their definition is extremely simple: if each new peak is higher than the previous one, then you have an uptrend . In a downtrend, each new peak is lower than the previous one, and in a sideways movement, new peaks are approximately in the same range. For a better understanding, see the picture below:

The author of the theory also divided the types of trends depending on trading ranges. So, according to the theory, there are three types of trends: primary, secondary, small. The primary trend is considered long-term, the secondary is intermediate, and the minor is short-term. For a simple understanding, open the chart of any currency pair and the first thing you can see is a large underlying trend.

It is, by Dow’s definition, primary, but we also see large pullbacks, which the author calls a secondary trend, but do not forget that both the primary and the secondary are not so straightforward and consist of small movements, which Charles called a small trend. In order to understand what we are talking about, I suggest you look at the picture below:

3) The primary trend consists of three phases

Charles Dow identified three phases of the primary trend, namely: accumulation, participation and implementation. The accumulation phase is the beginning or, more simply put, the turning point of the main trend and the emergence of a new one. The first phase is interesting in that it appears thanks to the most far-sighted traders who begin to buy or sell currency when the main participants do not see this and hope for the continuation of the trend.

As a rule, this movement is very small, and many perceive it as a rollback . The participation phase begins thanks to traders who use technical analysis and, seeing a new wave, begin to actively join it. During the second phase, the price travels a long distance, which leads to the formation of an obvious trend.

The implementation phase is interesting because it is included when the trend is already obvious, but it is during this phase that a turning point occurs, since the first two groups that participated in the first phases begin to close their positions and become against the trend.

The third phase can also be called the phase of hype, since it is during its formation that all TV channels and information resources trumpet the current situation on the market. To understand the three phases, look at the picture below:

 

4) Indexes must be consistent

First of all, this rule applies to the stock exchange and the two Dow Jones indices, and their rule states that if a signal appears on one index, then after some period of time a signal should appear on the second index.

In the forex market, this rule also applies, because if you see a reversal in one brand of oil such as Brent, then there will be a reversal in WTI. with currency pairs ; if you see growth on EUR/USD due to bad news on the dollar, then you should expect the same reaction on other currency pairs with the dollar as confirmation.

5) Trading volume must confirm the trend

Unfortunately, this rule is applicable only on the stock exchange, since the tick volume that we see on Forex does not reflect the real picture of the infusion of funds into purchases or sales. However, according to the theory, each trend should be supported by a monetary volume that reflects the real interest of market participants.

6) The trend lasts until new signals appear to change it

First of all, this rule tells us that any trend is not limited in time and will last until new factors appear that overturn it. There is a misconception among many that the trend is somehow tied to time, and if the graph goes up throughout the year, then it should soon reverse.

This misconception breaks down if you look at a chart of gold and count how many years it has been rising. 

Let me remind you that the Dow theory lies at the origins of technical analysis , so it remains relevant in the Forex market to this day.