Dow Theory and How it Works for Forex Trading

Here is yet another ramble about some forex trading concepts that you can use, if you can understand them that is. Today, we are gonna focus on Dow Theory and how you can use this to your benefit in your forex trading....

But first, a little ramble about Dow theory, how it became known as the "Grandfather of Chart Analysis Theory" and what is about...

The History of Dow Theory

Way back in the early 1900's, a fella by the name of Charles Dow started putting together a series of editorials which would define technical analysis as we know it today. The editorials (which are unfinished due to his health), were comprised of his thoughts on how the stock market behaved and how to use the market to judge the health of businesses and their environment.

Like I said, Dow never actually finished his theory but nevertheless his six theories are still used today by technical analysts. And while most of these theories are done with the Stock Market in mind, trust me, they can be transferred to literally any other market out there....the foreign exchange market included....

So without ado, here are the 6 theories...

1. The Market Discounts everything- This theory is basically built on the notion that all things...past, present and future are discounted and reflected in the prices. All things = emotions, inflation, interest data, ect.
2. The Three Trend Market- I will actually discuss this later in this rant because this theory can be immediately applied to forex trading. Basically, this theory deals with trend analysis and Dow believed that there were 3 main trends, the Primary Trend, the Secondary Trend and finally, the minor trend. Like I said, hold your horses...I will be expounding on this later....
3. The Three Phases of the Primary Trend- The Primary Trend is the long term trend. For instance, in forex terms, the dollar over the past couple years has been shrinking. Although there are rallies here and there, the dollar is continuing to shrink. There are three phases that Dow identified in a bullish market...Accumulation Phase, the public participation phase and finally, the excess phase. In contrast, Dow also noted that there were three phases in a bearish market...The distribution phase, the public participation phase, and finally, the panic phase.
   
4. Market Indexes Must Confirm Each Other-This is not relative to forex trading (although, I guess you could analyze a currency with other similar pairs)but in this theory, Dow basically says that both the indexes (the dow industrial and rail averages) would need to be in agreement with each other. So, in other words, if one of the indexes is indicating an uptrend while the other isn't, then there is no way to determine whether an uptrend is actually happening.
5. Volume Must Confirm the Trend- This theory basically implies that you should look at the volume of sales to confirm that there is a trend started. I kind of went over this in my forex trading support and resistance tutorial and understanding trader's remorse. It is no joke...The amounts of volume is critical to knowing when to buy and when to sell.
6. Trends Remain in Effect Until Clear Reversal Occurs- The trend is your friend..heard of that saying? It is true. The theory implies that the trend stays until proven that it is going in the other direction.

Great, you say...but what does this have to do with forex trading? After all, isn't the Dow Theory tailored to the Stock Market mainly?

Well, yes it is....but the Dow Theory deals with technical analysis and guess what? Most forex traders learn...technical analysis. So what parts of the Dow Theory can we glean and use to our benefit?

What You Should Immediately Understand about Dow Theory and Forex Trading

I mentioned that I would get back to the three different trends and which way they are going. As forex traders, we tend to get enamored with the here and now and many of us use the 5,10, and 15 minute charts. However, if you were to exclusively use these charts to identify overall trends in a market, you would likely be surprised when things whip saw back on you in your forex trades.

Hence where the three trends of dow theory come into play...

I already mentioned that the primary trend can sometimes take years to establish itself and is really a long term trend that you can identify the overall health of the currency pair. However, you wouldn't notice this if you were simply charting out hourly or even daily charts. You should always identify the primary trend of whatever currency pair you are trading.

How do you identify an upward or downward trend?

As you probably have found out, normally the market is nothing more than a series of rallies and sell offs. According to Dow, for a market to be trending, each rally point should be be higher than the previous rallies high. Each sell-off point, should be lower than the previous sell-off point.

In other words, for a market to be trending up or down according to Dow Theory, it must be consistantly moving upwards or downwards. I should note, that Dow didn't do much intra-day trading. Instead, he focused on the closing price each day.

The secondary trend is even more important to the forex trader who is trading for the quick buck because these trends tend to last from a couple weeks to a few months. Once again, the same theory applies....a market must be outpacing its previous highs or lows to qualify as a trend.

Finally, the minor trend....this trend can actually go against the primary trend and doesn't last very long. Typically these trends can happen from forex news but normally are quickly corrected.

That is pretty much it. If you can identify the primary trend of whatever currency pair you are playing around with, the rest is a cakewalk. Well....sort of....Dow's Theory might have been made for the Stock Market folks, but as you can see, it can be applied to the forex market as well....