Technical analysis, much like other concepts and notions in trading, took a very long time to develop and evolve to be the form that it currently is. Dow Theory is the name referred to a very form of technical analysis.
The reason it is named so has to do with the person behind this theory. A person named Charles Dow was the first one who theorized that prices in the stock market can move high or low according to trends. This means they might move based on certain patterns. Patterns that can be recognized and used to the benefit of the trader. This is how the seed of technical analysis germinated into roots.
In this article we are going to take a look at Dow Theory and see how it ultimately turned into more sophisticated methods of technical analysis. Although it is mainly related to the stock market, we will also see how it can be related to the forex market.
Looking at the Roots of Dow Theory
As it was mentioned, Dow Theory was first developed by a trading expert named Charles Dow back in 1897. It is considered one of the oldest concepts of market analysis in the whole field of trading and investment.
As a result of this theory, he introduced two averages in the market. One of these averages was known as the industrial average, which as the name suggests was related to certain stocks belonging to industries. And the other one called rail average, which again as the name suggests included companies related to the rail industry.
We will go through more details of Dow Theory in the next sections. But the fundamentals of this theory have their roots in a number of articles that were published by Charles Dow during the same period.
These articles and theories were so foundational that they now make the basis for many market analysis theories today, including the Dow Jones standards.
Why Was Dow Theory Developed?
We have already mentioned that Dow Theory came to form the basis for many of the theories that we now have today with regard to technical analysis. What it came to be is different from what it was originally intended for.
Although it has since been heavily involved in a large and extensive array of theorizations used in market analysis, Dow Theory was not originally intended to be used as a form of technical analysis.
This means, Charles Dow did not intend to use his theories as a means of technical analysis to find signals in the market which would have ultimately led to profits.
Instead, his main intention was to use such theories and understand the market deeper and better as a whole. He merely wanted to get a deeper insight into the world of business.
What Are the Principles of Dow Theory?
This is where things get interesting. The principles of Dow Theory include so many foundational ideas and concepts that we even use today in many different technical analysis approaches and tools. Let’s take a look at some of the most important principles in this theory.
Although there is a particular order in how these principles are presented below, each one of them can stand alone and still be fully meaningful.
Also please remember that although we always try to have a forex perspective in mind, the Dow Theory was originally developed for the stock market. So the original principles that are offered below are all based on the stock market as well.
Three Main Trends in All Markets
Under any condition in the stock market, there can be three main trends – primacy trend, secondary trend, and minor trend.
The primary trend, as it is aptly named, is the most important trend in many regards. First of all, in terms of time frame, a primary trend can last for a year or perhaps years more. So it is a long term trend. Also, in terms of potency and strength, a primary trend can be responsible for 20 percent of all price changes.
Then there are secondary trends. These trends are only there to cut primary trends. For this reason, secondary trends go in the opposite direction of primary trends. Secondary trends can last for weeks. Their main purpose is to cut the primary trend and they do not last for very long.
The last type of main trends is known as minor trends. These are the daily trends that form the ups and downs in the market as part of ordinary and daily fluctuations.
Different Phases of a Main Trend
To talk about the three different phases of a main trend, let’s look at the different types of a primary trend.
First, there is a primary trend that goes higher and higher, otherwise known as a bullish primary trend.
- Accumulation: this is where the trend is in its early formation and expert buyers are paying more and more attention to the asset.
- Steady advance: this is where the trend has formed and its basis has become stronger. It is at this point where the smartest traders get into the game.
- Phenomenal advance: and this is the last phase after the full formation of the trend. This is where even ordinary buyers are attracted to the trend.
Second, there is another form of primary trend that registers lower and lower, also known as a bearish trend.
- Distribution: this is the basis of a bear trend. At the early stage of a bearish trend, investors and expert traders will begin to sell their positions because they anticipate decreases in value.
- Panic: the second phase is also part of the initial formation of the trend. At this point, many traders in the market will rush to sell their position because they have panicked.
- Discouraged sale: that last phase is where the inclination of the bearish trend is lighter and slower. But it still includes later sellers who were convinced later on to sell their position.
The Relationship Between Dow Theory and Forex
So how does Dow Theory relate to the forex market?
The way this theory is useful in the forex market can easily be seen in its principles. Dow Theory has introduced many important concepts in trading. Including the formation of trends, either bearish or bullish, and breakouts or reversals from the break.
And trend trading is just one type of trading strategy in forex trading that employs trends as the basis of its strategy.
Whole other types of trading and strategies also rely on the formation of trends and detecting them at the right time.
Dow Theory is one of the most fundamental concepts in technical analysis. This theory was first introduced by a market expert named Charles Dow back in the 19th century. It involves some of the most important notions, including the importance of trends in driving the market and prices, in addition to various types of trends, their phases, trend reversals, and many other notions that have come to form the basis of technical analysis as we know today.