Dow’s theory and application to forex trading

Dow’s theory forms the basis of graphical analysis. All principles and techniques of graphical analysis (or chartism) are ultimately just developments, applications and special cases of Dow’s theory.

Developed for stock market analysis in the late 19th century, all elements of this theory are not necessarily directly applicable to Forex.

Instead of exposing Dow’s original theory, in this lesson we will introduce principles and techniques directly applicable to trading in the currency market.

The definition of a trend according to Dow’s theory

Before defining trends according to Dow’s theory, it is necessary 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 move in a straight line for long. Currency developments are therefore made up of small upward movements and small downward movements, which, considered end to end, constitute trends.

Peaks and bottoms, also called “highs” and “lows”, are therefore the turning points of the “small movements” that make up the trends.

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

In an uptrend, each new high must be higher than the previous one and each new low must be higher than the previous one.
In a downtrend, each new low must be lower than the previous one and each new high must be lower than the previous one.

upward trend

bearish trend

Charles Dow, who, as the name suggests, laid the foundation for Dow’s theory, used a very clever metaphor to explain this principle, comparing the evolution of prices to the tide.

In fact, as the waves advance more and more on the beach, the tide rises. Conversely, as successive waves move further and further away from the beach, the tide drops.

The same goes for the trends of the charts, if the highs are always higher, the general trend is bullish, if the lows are always deeper, the general trend is bearish.

How to use this principle in practice?

First, a trend that follows these rules is more likely to continue. A trend that does not respect these rules therefore sends early signals of the end of the trend, or weakening

If we had to choose between two operations, we would therefore prefer to follow a “healthy” trend, which respects this rule.

So, if we have taken a stand on a healthy trend, which then adheres less and less to the above principles, 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 fit together

The basic concept of Dow

In his theory, Dow stated that “the market has three trends” and that a trend is divided into three parts: the primary trend, the secondary trend and the minor trend.

To use the metaphor of the tide, we can consider that the primary tendency is the movement of the tide, the secondary tendencies are the waves and the minor tendencies are the lapping that forms over the waves.

The Forex app

However, forex is a market where everything happens very fast, and what’s more, it didn’t exist when the Dow theory was formulated, and this trend study view is not very suitable for trading in the currency market.

It is indeed more relevant to consider the movements of currency pairs by making a comparison with Russian dolls, these statues of different sizes that fit into each other.

For example, when you spot an uptrend on a daily chart, you can see “zoom in” on the 4 or 1 hour chart that the overall uptrend you have identified consists of successive ups and downs.

If you isolate one of these small rises or falls and “zoom in” with a 15-minute or 5-minute chart, you will see that this movement is itself made up of small rises and falls, and so on.

There are therefore more or less long-term trends in forex. Some lower trends can last for years on very long-term charts, while shorter trends on smaller charts can only last a few minutes.

It is therefore interesting to know the context in which one enters when trading in the short term: is the underlying trend bullish or bearish?

In fact, you must answer this question before even trying to position yourself on the market, because as you have surely already heard, IT’S BETTER TO TREND IN THE DIRECTION OF THE TREND.

How come? Because if you get it wrong, if you put yourself in position too early or too late, the general trend will work in your favor if you have positioned yourself in its direction, while it will only increase your losses if you have sailed against the tide …

However, we shouldn’t go too far back. In fact, if you trade for example on 1 minute charts, it is of little use to identify the general trend visible on the daily chart.

The idea is to identify the trend in which the trend you want to follow fits, the “next term” trend.

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