Lesson 10: Dow Theory and Application to Forex Trading

Dow's theory is the basis of graphical analysis. All the principles and techniques of graphic analysis (or charism) are ultimately only evolutions, applications and particular cases of Dow's theory.

Developed for the analysis of equity markets at the end of the 19th century, all elements of this theory are not necessarily directly applicable to Forex.

Rather than merely exposing Dow's original theory, we will present in this lesson the principles and techniques directly applicable to trading on the currency market.

The definition of a trend according to Dow's theory

Before defining the trends according to Dow's theory, we need to take stock of the notions of "peaks" and "troughs", which serve as the basis for the definition and analysis of trends.

Regardless of the time scale, currency pairs rarely change long in a straight line. Currency movements are thus made up of small upward movements and small bearish movements, which put end to end are trends.

The peaks and troughs, also called "higher" and "lower" are therefore the turning points of the "small movements" that constitute the tendencies.

The definition of trends according to Dow's theory is therefore based on the study of these successive peaks and troughs:

As part of an uptrend, each new "higher" must be higher than the previous one, and each new "lower" must be higher than the previous one. 
In a bearish trend, each new "lower" must be lower than the previous one, and each new "higher" must be lower than the previous one.

Charles Dow, who as his name suggests laid the foundations of Dow's theory, used a very intelligent metaphor to explain this principle, comparing the course evolution to the tide.

Indeed, when the waves advance successively farther and farther on the beach, the tide is rising. Conversely, when successive waves move further and further away from the beach, the tide is descending.

The same is true of graphic trends, if the peaks are always higher, the general trend is bullish, if the troughs are deeper and deeper, the general trend is bearish.

How to use this principle in practice?

First, a trend that respects these rules will be more likely to continue. A trend that does not respect these rules therefore sends advanced end-of-trend signals, or weakening

If we have a choice between two operations, we will therefore prefer to follow a "healthy" trend, which respects this rule.

Then, if one takes a position on a healthy trend, which then less and less respects the principles mentioned above, it may be wise to get out of position before things get tough.

The concept of "Russian dolls", or how the trends of different terms are interwoven with each other

The basic concept of Dow

In his theory, Dow said that "the market has three trends", and that a trend is broken down into three parts: primary trend, secondary trend and minor trend.

To take again the metaphor of the tide, one can consider that the primary tendency is the movement of the tide, the secondary tendencies are the waves, and minor tendencies are the lapping that form above the waves.

Application to Forex

However, forex is a market where everything happens very quickly, and moreover that did not exist when formulating the Dow theory, and this view of the trend study is not very suitable for trading On the currency market.

It is indeed more pertinent to consider the movements of currency pairs by making a comparison with Russian dolls, these statues of different sizes that interlock with one another.

For example, when you spot an upward trend on a daily chart, you can see by "zooming in" on the 4h or 1h chart that the general bullish trend you have spotted consists of successive increases and decreases.

If you isolate one of these small increases or small drops and you zoom in with a 15-minute or 5-minute chart, you will see that the movement itself is made up of small hikes and small drops, and so on.

There are therefore more or less long-term trends in forex. Some background trends may last for years on very long-term charts, while the shortest trends on smaller charts may last only a few minutes.

It is therefore interesting to know the context in which we are engaged in short-term trading: Is the underlying trend bullish or bearish?

You have to answer this question before you even try to position yourself in the market, because as you have certainly heard, IT IS PREFERABLE TO TRADER IN THE MEANING OF TRENDS.

Why? Because if you make a mistake, if you go into position too soon or too late, the general trend will be in your favor if you have positioned yourself in its direction, while it will only increase your losses if you sailed against current…

However, we must not take too much distance. Indeed, if you trade for example on charts in 1 minute, it is little useful to locate the general trend visible on the daily chart.

The idea is to spot the trend in which the trend that you want to follow, the trend of "directly superior term".