Dow Theory – Fundamentals of Trend Analysis

Initially, the principles of the Dow theory were used only for the American indices created by Charles Dow: Transportation and Industrial. However, they can be successfully applied to the forex market.

  • The indices tell it all. According to Charles Dow, any factor that influences supply and demand will be reflected in the index. These factors cannot be foreseen, however, they are considered by the market and are reflected in the performance of the index.
  • There are three movements in the market. The upward trend is characterized by the fact that each maximum is higher than the previous one and each minimum is higher than the previous one. The downtrend is characterized by the fact that each minimum is lower than the previous one and each maximum is lower than the previous one. When the market is flat, each next step (up or down) is roughly at the same level as the previous one:

  • Dow classified market trends as follows:
    • primary trend: It is broad and can last from less than a year to several years.
    • secondary trend: Its duration is average, three weeks to three months, and the primary trend is considered as a correction trend.
    • daily trend: It is a short-term movement within the secondary trend with a very short-term duration.

      Another classification was suggested by Thom DeMark :
    • short-term trend: if the variation in price is less than 5%.
    • medium-term trend: if the price has moved more than 5% but less than 15%.
    • long-term trend: price variation greater than 15%.DeMark devised a forecasting method to predict the beginning of a trend, medium-term and long term. The method is based on specially designed coefficients.
  • The primary trend has three phases. During the first phase, all unfavorable market information has been discounted by the market and the best-informed traders begin to trade. The second phase begins when traders doing technical analysis enter the market. Once all the economic data becomes more favorable, the final phase begins, which is characterized by high activity in the market supported by the media and optimistic economic forecasts in the newspapers and on TV. Despite the positive sentiment, the final phase is the first sign that the prevailing trend is around its extreme.
  • The indices must be confirmed for the signal to be authoritative (the industry and transportation indices referred to). Charles Dow said that any significant signs of the uptrend or downtrend in the market should be considered together in the industrial and transportation indices. If we now apply this principle based on modern technical analysis, it would mean that a signal from one technical indicator should be confirmed by a signal from another technical indicator.
  • Trade volume should confirm the prevailing trend. If prices move according to the prevailing trend, volume increases and vice versa, when there is a rebound, the volume traded decreases.
  • The primary trend remains intact until a change in that trend has been given by theory. The main signal continues to prevail until a new signal appears. Many analysts believe that a bull market should always move to new highs. However, the market can experience extended periods of skew without causing the primary trend to change. If the main past signal is theoretically bullish, the prevailing long primary trend continues until a bear market signal occurs.

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