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Six Tenets of Dow Theory

dowieThis article present basics of Dow Theory which is an absolute must for beginners of forex. The father of forex technical analysis Charles Dow was the founder of Dow Jones and Company which publishes the Wall Street Journal. Around 1900 he published a series of research papers to analyze the way prices the dynamics of prices at the Dow Jones Industrial Average and the Dow Jones Transportation Index.

The papers claim that the markets tend to behave in similar ways over time. These ideas generalized by other traders in the years that followed, became known as “Dow Theory”.

Its is surprising that although Dow Theory was invented over 100 years ago most of its points are still relevant today for forex analysis. Knowing the basic principles of this theory is an absolute must for beginners of forex.

The theory comprises of six basic tenets

The first tenet is that the markets are characterized by three trends.

  • Up trends are defined as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows.
  • Down trends are defined as when the market makes successive lower lows and lower highs.
  • Corrections which are defined as a move after the market makes a move sharply in one direction where the market retreats in the opposite direction before going in its primary track.

The picture below exemplifies the first tenet

Dow_Figure_1 

The second tenet claims that trends are characterized by three phases:

  • The accumulation phase which is when the professional traders are taking positions against the majority of the traders . The price does not change much at this phase since the “experts” are in the minority.
  • The public participation phase which is when the majority of the traders realizes what the “experts” know and begin trading in the same direction. This causes a rapid movement of the price
  • Finally, the excess phase is when uncontrolled speculation occurs and the professional traders exit their positions.

Since these phases are periodic you can now see how the psychology of investors and traders works. The Figure below exemplifies the concept of three phases by run-up up the NASDAQ into 2000.
Dow_Figure_2

The third tenet is that the markets discount all news, means that once news is released it is almost immediately reflected in the price of an asset.

“the efficient market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.” Source: Wikipedia

The idea that the market discounts all news is in favor of using technical analysis. If it is true that markets already discount all fundamental factors then fundamental analysis is not important and the traders must focus on the actual movements of the market.

Tenet four of Dow Theory is that The Averages Must Confirm Each Other. The averages must confirm each other. Here Dow was referring to the Dow Jones Transportation Index and the Dow Jones Industrial Average. To understand this point it is important to remember that in Dow’s time the growth in the US was coming mainly from the Industrial sector. These two indexes were made up of manufacturing companies and the rail companies which were the primary method used to ship the manufacturers goods to market. What Dow was basically saying here is that you could not have a true rally in one of the averages without a confirmation from the other (see Figure below).

Dow_Figure_3

Tenet five is that the trends are confirmed by volume. What Dow was saying here was that there are many reasons why price may move on low volume, but when prices move on high volume there is a greater chance that the move is representative of the overall market’s view. Recall that volume consists of the total amount of currency traded within a period of time, usually one day.

Dow_Figure_4

Tenet six is that trends exist until definitive signals prove that they have ended. What this tenet means is that there will be market moves which are against the primary trend but this does not mean that the trend is over. The market will normally resume its original trend. Nowadays there is an ongoing debate on how to best define this definitive “golden” signal that the forex trend is over. However, this subject is outside the scope of this paper.

Now, you have read this article and you have a basic understanding of the Dow Theory. You may start learning about forex indicators and other interesting and exciting materials relative to the technical analysis on forex online trading such as our Collection of Forex Patterns and Exit Strategies

Read: The Market Knows Everything: Dow Theory

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