Forex Education basics: Dow Theory

Forex Education basics: Dow Theory

Dow Theory, the father of technical analysis

The Dow-Jones is will sound familiar to anyone with a remotest interest in the financial markets. Charles Dow and Edward Jones founded Dow-Jones & Company in 1882; they published editorials in the Wall street journal in July 1884 outlining their basic ideas, which most technical traders will recognise. Dow Theory today forms the foundations of technical analysis despite new computer technology and supposed better technical indicators, Dow is the daddy of technical analysis.

Dow published the first ever market average based on closing prices of eleven stocks; nine railroad and two manufacturing companies, in 1884. Dow said that these eleven stocks gave a barometer for the economic health of the United States of America. In 1897 Dow furthered the indicator with two separate indices, he felt this would provide a better indicator, creating a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial index had grown to include thirty stocks, today’s number. A utility index was included by the Wall street Journal in 1929.

Dow theorised over the averages he had produced, the Industrials and Railroad, nevertheless his analytical theory equally applies to all market averages.

Dow Theory, the basic tenets

The averages discount everything; the total and tendency of the transactions on the stock exchange relates to the sum of all Wall Streets knowledge of the past, present and future. Wall Street considers all and acts accordingly.

The market has three trends (two discussed); An up trend defined as a situation where by each successive rally high (peak) closes higher then the previous rally high and that each successive rally low (trough) closes higher then the previous rally low.

A Down trend being the opposite, lower peaks and troughs define the down trend.

Dow also considered a trend to be made up of three parts, primary, secondary and minor. He used the ocean to describe these as Tide, Wave and Ripple.

The primary trend he equated to the Tide, the secondary the Waves that make the tide and finally the ripples on top of the waves or minor trends. A trader can therefore decide direction of the tide by noting the highest points of the wave on a beach by the next series of waves, if each successive wave reaches further up the beach then the tide can be stated as coming in. When the highest point of the wave recedes, the tide has turned and can be stated as going out.

Dow felt that the tide of the markets lasted more then a year and as long as several years. The secondary, the wave, represents corrections of the primary market and normally last three months to three weeks. These wave corrections generally retrace between one-third to two-thirds of the previous trend the average being about half of the previous trend.

Dow felt the minor, ripple, lasts less then three weeks, which represent fluctuations in the secondary trend, the wave.

The Major trend has three phases

Dow fixed his attention on our primary trend, which he states has three key phases:

The accumulation phase: Informed buying by the most astute traders, if the previous trend was down, then this is the point at which astute traders realise the market has absorbed all the “bad news”.

The public participation phase: most trend followers begin to participate, occurring when prices begin to advance rapidly and business news improves.

The distribution phase: Economic news is better then ever, speculative volume increase and public participation increases. During this phase the same informed traders who accumulated near the bear market bottom begin to distribute before anyone else starts selling.

Those that have studied Elliot wave theory will identify this division of a trend, R.N. Elliot built upon on Rheas work in Dow theory, Dow really was the Father of technical analysis.

The averages must confirm each other

Dow stated that no important move signal could be correct unless it is confirmed by another reference. In Dow’s case he was referring to the Industrial and Rail Averages he devised. He felt that both the Industrial and Rail averages must signal the same indication to be confirmation of the move. He also felt that the signal did not have to be simultaneous, but recognised that the shorter the period of time between both signals the more powerful an indicator. Conversely if the two signals diverged the assumption is that the prior trend was still maintained.

Volume must confirm the trend

Simple, volume should expand or increase in the direction of the trend. Savvy traders would use volume to confirm their primary forecast of price action.

A trend continues until it gives definite signals of reversal

Mentioned earlier relating to Newton’s law of motion; an object in motion tends to continue in motion until some external force cause it to change direction, in our case it’s a trend.

A Technicians most difficult task is to distinguish between a normal correctional movement and a new leg of a new trend. Utilising Dow’s initial definition of a trend we now have two scenarios in which a market can change direction by breaking the trend definition.

Closing prices only please

Dow theory uses exclusively closing prices, as Dow believed that the price had to close higher than a previous peak or lower then a previous trough to be valid. Dow’s theory assumes intra-day penetrations as invalid.

The third trend

Ranging, sideways, lines in the average, rectangles are all terms referring to the third trend of Dow’s theory. These sideways trends are normally corrective in nature often called consolidations.

Application: Dow theory on futures markets

Dow worked with Stocks on the major trend where buy and hold is a valid trading strategy. Futures present the trader with the added problems of high leverage and this brings the intermediate, the most followed and the minor trend.

Scaling down Dow to fit the futures market must be made. Dow assumed that most stock traders/Investors would use the intermediate correction phase for timing purposes to enter the major trend. With futures we scale down the process and pay attention to the minor trend for timing purposes.

If a trader expected a intermediate trend to last for a few months we would then look at near term dips in the market for our timing purpose-

Dow theory conclusion

If you applied Dow theory to recorded data over the last one hundred plus years you would have captured 67% to 75% of all market moves on the Industrial averages and the Standard and Poor 500 (Barons). Although Dow theory misses up to 25% to produce a signal and normally enters in the second stage of a trend, around the same time as most modern trend-following technical systems, it must be remembered that Dow did not intend to forecast trends. Dow sought to be aware of the emergence of a Bull or Bear market and capture the large central section of the important move, not bad for an old man.

Robert Woodbridge-Lee
Sunrise FX
00372 5023761

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