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The Market Knows Everything: Dow Theory

charlesdowCharles H. Dow (Nov. 6, 1851 - Dec. 4, 1902) developed his remarkable market theory while living a colorful life as a newspaper reporter, financial writer, broker, analyst, and editor. He is a father of the modern technical analysis of forex. Technical analysis is a controversial set of methods for forecasting the forex market based on the historical price and volume combined with the investor sentiment.

The main instruments of the technical analysis(see Relevancy of Technical Analysis in Forex Trading) are charts , patterns as well as technical indicators. The technical indicators are a result of the mathematical and statistical analysis of average characteristics of the price movements.The ground rules of the forex technical analysis based on the Dow Theory summarized below:

“The market knows everything”: The price is an image of the market forces and market information.

“Trend is your friend”: Price follows trends. The trends are classified as follows : up trends (bullish), downtrends (bearish) and flat trends (sideways).

“The history repeats”. Price movements display periodically emerging patterns. The Dow market is characterized by three trends:

  • the major (1 year or more ) also called primary,
  • intermediate (1 month and more) also called secondary
  • minor (several days ) minor.

The primary trend consists of three intervals: accumulation, run-up/run-down, and distribution.

At the accumulation step of a bullish market only the most intelligent traders enter new positions. In the run-up/run-down phase, the mainstream of the market finally recognizes the move and jumps on the bandwagon.

Finally, comes the distribution phase. The keenest traders collect their profits and exit the positions. The general trading interest slows down in an overshooting market. The secondary trend is correction to the primary trend and may retrace one-third, one-half or even two-thirds from the primary trend.

Volume must confirm the trend. Volume consists of the total amount of currency traded within a period of time, usually one day. Large trading volume implies that there is huge interest and liquidity whereas the low volume tells the forex trader to exit.