Charles Dow is one of the pioneers of technical analysis and developed a theory for market movements. While his theory and assumptions were based on, and applied to, the stock market and stock indexes, several of the concepts are useful in other markets, such as forex, futures and commodities.
Dow Theory is based on a number articles published between 1900 and 1902 in The Wall Street Journal. He created two averages, now known as the Dow Jones Industrial Average and the Dow Jones Transportation average (originally the Rail Average). Using these averages Dow came up with six assumptions about the market, which I believe still hold value (5 of them especially), and are useful for understanding the overall movement of prices.
Here are the six concepts and how they can help you as a trader:
1. The Price (or Average) Discounts Everything
The current price reflects all known information about an asset. As market participants receive new information, the price adjusts accordingly. On a personal note, I feel it is very important to not get bogged down by thinking others have information you don’t, or that you can find out something the rest of the market doesn’t know. Trust that what the price is doing is a reflection of the overall sentiment of market participants.
2. The Market is Comprised of Three Trends
No price moves in a straight line up or down. Yet many traders expect it to, thinking–or hoping–a trend will last forever. Even during strong trends, when it seems like everyone is a buyer or seller, there are in fact three trends in play: Primary, Secondary and Minor.
The Primary trend is the main trend for the market, often seen on longer-term charts such as the daily or weekly. These trends typically last for years and are either rising (bullish) or falling (bearish). A rise occurs when the market you’re trading is making higher highs in price and higher lows. A decline occurs when the price makes lower lows and lower highs. While traders typically use longer-term charts to determine the Primary (and Secondary) trend, it is all relative to your own time frame. If you trade one minute options or use a one minute chart, the Primary trend may be a 5 or 15 minute showing a day or two of price data.
A Secondary Trend is a corrective reaction to the Primary Trend. Typically these corrective reactions retrace about 25% to 75% of the last primary move.
Figure 1. Primary and Secondary Trends
Figure 1 shows Primary and Secondary trends. The overall movement is up (Primary trend) but corrections continually occur, and are marked as Secondary trends. This is a daily chart, but if you short-term trade this could just as easily be a 1, 5 or 15 minute chart. Find the Primary trend that is dominating the time frame you’re trading on, and label it accordingly. Corrections against that Primary are Secondary trends.
Finally, there are Minor trends. These are minor fluctuations that occur within the Primary and Secondary trends. These gyrations are often called “market noise” since they only serve to distract you from the real profit potential created by Primary and Secondary trends. Whatever time frame you’re trading, find your Primary and Secondary trends, and don’t bother with trying to profit from minor (and usually random) trends.
3. Primary Trends Have Three Phases
Once you’ve isolated the Primary trend on your time frame, you’ll notice it can often be divided in three main phases, an initial, second and third. This aligns with the Elliott Wave theory that trends typically unfold in three impulse waves.
Figure 2. EUR/USD Three Phase Trend
In Figure 2 the trend unfolds in three major waves higher, highlighted in blue. The trend is up during these three phases overall, as the EUR/USD is making higher highs and higher lows. After the third wave though, the price declines and starts making lower highs and lower lows (a downtrend). Therefore, once you have three major moves completed–higher in the case of an uptrend, or lower in the case of a downtrend–a more significant reversal is likely forthcoming.
4. Averages Must Confirm Each Other
If you are a stock trader, or trade options related to stocks or stock indexes, this may be applicable, but I find it to the least useful of all the concepts. The basic idea is that if stock indexes (we have many more than Dow had in his day) are moving together it confirms the direction. But when indexes are moving in different directions, or not confirming each other, it is not the ideal time to make trades.
5. Volume Confirms the Trend
Volume is an important piece of the puzzle when trading, as it tells you how much interest there is behind price movements. Relatively low volume means the price movement isn’t as important as price moves which occur because of large volume. When possible, analyze volume of the stock or futures contract you’re trading. The basic rule is that volume should increase with the Primary trend to provide some confirmation of the movement. Ideally you want to volume to rise as the trend rises, as well as volume to rise when the trend is down. While volume can be a great additional tool, price movement should always be the primary focus.
6. A Trend Remains Intact Until It Gives a Definite Reversal Signal
If an uptrend is a series of higher highs and higher lows, then a definite reversal signal occurs when there is a lower high and a lower low.
A downtrend is lower highs and lower lows, so a reversal occurs when there is a higher high and a higher low.
Figure 3. Trend Reversal in USDZAR
Figure 3 shows a reversal from a downtrend to an uptrend. In the highlighted blue area the price makes a higher high in the USDZAR, followed by a higher low. It then proceeds to make more higher highs and higher lows.
Final Word
While implementing a theory is never as easy as the theory sounds, a basic understanding of Dow Theory should help you in your trading. Markets never move in straight lines, and trends don’t last forever. This theory provides general guidelines for how markets move and how you can trade those moves. Always practice and hone your strategies before using real money, and make sure you have solid money management skills before trading.