The Dow Theory

Any efforts to track down the beginnings of technical analysis will lead the reader to an introduction to Dow Theory. The Dow Theory was developed by Charles H. Dow in the 19th century. Initially, the Dow Theory was used to describe stock price movement. It compares the Dow Jones Industrial Average to the Dow Jones Transportation Average and was used to identify if we’re in a technical bull market or in a technical bear market. To confirm if the market is in a technical bull market or a bear market the trend for the DJIA should match the trend for the DJTA. An important part of the Dow Theory is the foundation of everything we know about technical analysis.



Because the Dow Theory is a form of technical analysis that focuses on establishing the overall direction of the market, this makes it a universal tool that can be applied to other asset classes like Forex currencies.

The basic premise of the Dow Theory is very simply to serve as an indicator of the general health of the market. The following are the six principles of the Dow theory:

  1. The price discounts everything.
  2. The market has three trends.
  3. Trends have three phases.
  4. The averages must confirm each other.
  5. Volume must confirm the trend.
  6. A trend is assumed to be in effect until it has given a definite signal that it has reversed.

Price discounts everything

Dow theory states that all known information, that can be known, has already been factored into the price.   Therefore the news has been discounted. The only remaining influence on the price is human emotion. That said, Dow Theory would say that we’re then studying human emotion and not the statistical data because studying the price action is only a reflection of human emotion.

A Market has three trends

Dow Theory stipulates that there are three important trends in a market. An uptrend is defined as successive higher lows followed by successive higher highs, while a downtrend is defined as successive lower lows followed by successive lower highs.

  1. Primary trend.
  2. Secondary trend or Intermediate trend.
  3. Minor trend or daily fluctuation.

The primary trend generally lasts between one and three years. This is the most important trend because it will impact the secondary and minor trend as well. The secondary trend generally lasts between three weeks and three months and it moves in the opposite direction of the primary trend. The minor trend generally lasts less than three weeks. The daily fluctuation is going to remain relative to the intermediate trend, the same way that the intermediate trend remains relative to the primary trend.

GBP/USD Daily Chart

Three Phases of a Trend

A trend has three phases as follows:

  1. Accumulation Phase.
  2. Public Participation Phase
  3. Distribution Phase.

EUR/USD Chart

The accumulation phase is the first stage of a bull market and represents smart buying by the most informed traders. Generally, the accumulation phase appears at the end of a bearish trend and is characterized by extreme negative sentiment. On a price chart, the accumulation phase is characterized by a period of consolidation in the market.

The public participation phase occurs when the price starts to move rapidly and is the phase where most trend followers start to participate. The public phase lasts the longest and is the phase with the largest price movement.

The distribution phase is the first stage of a bear market and represents smart selling by the most informed traders. This is the opposite of the accumulation phase and generally is characterized by optimistic sentiment and fundamental data looks better than ever.

Averages Must Confirm Each Other

This principle states that the overall direction of the trend must be confirmed by a correlated pair, thus confirming each other. If for example, the EUR/USD is moving in an uptrend, consequently we should see the primary GBP/USD trend moving up. However, if GBP/USD doesn’t confirm the EUR/USD we have divergence and something is not right and consequently, there can be a big change in the trend coming soon.

EUR/USD vs. GBP/USD Daily Chart

Volume Must Confirm the Trend

According to Dow Theory, volume should move in the direction of the primary trend. If we’re in a bull trend we should see an increase in buying volume, and conversely, if we’re in a bear trend we should see an increase in selling volume. Weak volume indicates a possible weak trend.

A Trend is Assumed to Continue Until it Has Given A Definite Signal that it Has Reversed

According to Dow Theory, a trend is expected to remain in effect until a major event takes place that would cause a reversal. This principle is the starting point of the trend following systems. We want to stay in the general direction of the trend until it’s given definite signals that the trend has reversed. Like the law of physics, we assume that an object in motion will continue to stay in motion until an external force causes it to change direction.

Conclusions

Understanding the Dow Theory will give you a better grasp of technical analysis and subsequently will make you a better trader. In summary, Dow Theory is a set of general rules and principles for a better perception of the overall price action in the market.