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The Charles Dow Theory or Where the Technical Analysis Came From

11:17 AM Feb 21, 2020
10820
Forex trading

Do you know anything about Charles Dow? Is Dow theory a good choice for Forex trading? Nowadays, many traders still use Dow signals to make money, so this article can help you understand the Dow Forex theory.

Some things are much older than you think. Did you know that technical analysis of the Forex market originated over a hundred years ago? There were no computers in the XIX century and people couldn’t examine in detail the price movement down to every candle. However, the ideas that appeared at that period lie at the heart of determining the further behavior of the market to this day. The creator of these unique ideas was Charles Dow. He began as a simple reporter and subsequently became the founder of technical analysis.

In order to fully comprehend how any financial market works, why price behaves this way or another, what sets and reverses trends you need to return to the origins of this theory, understand what its basic concepts are and what they are caused by.

Origins of the Dow Theory

Charles Dow began his career in finance as a reporter for Wall Street. Later, with his partner Edward Jones, he created a separate company, Dow Jones & Company. They started by releasing a small two-page daily booklet in the finance world. Later, their small business grew and became one of the largest publications in the world of finance, known as The Wall Street Journal.

In his spare time from working in the publication, Dow tried to figure out how the market works. He was fascinated by the price movement and he was desperately trying to understand its logic.

Everyone knows that the market is driven by supply and demand. Prices rise when traders buy and drop when they sell. It is also known the market is not able to maintain a constant mood. That’s why the price forms waves or swings on the charts. Dow’s goal was to understand how the mood of traders affects the behavior of the market. All this formed the basis of his theory.

And it was just the basics because Charles Dow didn’t form the final idea. Other people later did it for him:

  • Sam Nelson
  • William Hamilton
  • Robert Rhea

Thanks to these three people, in 1932, the Dow theory acquired the form in which it is available to us today.

Main Concepts of the Dow Theory

If you think about Charles Dow’s idea you begin to understand that the market is like a living creature that behaves according to its own laws and is subject to sentiment. Once you delve into the basic principles of the Dow theory you will begin to understand how the market works.

Everything Is Priced In

Dow believed that every price movement takes into account all known information, including economic indicators of all countries, companies, and banks, any potential risks, and even the mood of market participants.

This does not mean that it is possible to predict what will happen in the future. Each price movement takes into account all new incoming information that cannot be known in advance. That is why there is no single way to predict market movement with 100% accuracy.

There Are Three Types of Trend

You might think that I mean the uptrend, downtrend, and sideways trend. However, Dow talked about something else. Given that the price moves in a zigzag fashion we can distinguish three main types of trend:

  1. Primary trend. This is the major trend that shows the general direction of the market movement. All other types of trends behave based on the direction of the primary trend. As a rule, its duration is 1 to 3 years.
  2. Secondary trend. This is a price swing that moves in the opposite direction from the primary trend. Volatility on the secondary trend is usually higher than on the major one.
  3. Daily fluctuations. The third type of trend is a pullback from the secondary one and lasts no more than one week. This type of trend is characterized by a large amount of market noise.

Primary Trend Has Three Phases

Everything has its beginning, middle, and end. The same applies to the trend:

  1. The Accumulation Phase. This is the period when the price is trying to gain a foothold and build up strength before the main movement. As a rule, this is part of the previous trend that already started to weaken. This is the most attractive but the riskiest entry point.
  2. The Big Move Phase. This is the main and longest part of the life of the trend.
  3. The Excess Phase. During this period, the price begins to behave irrationally, unstable, the number of corrections is growing. At this time, most traders exit their trades.

Trend Should Be Confirmed by Volume

Dow noted that the volume of transactions grows when the price direction matches the major trend and declines when it pulls back. Thus, with an uptrend, the volume should increase with rising prices and decrease when they fall. If everything happens the other way around and during the pullback, the volume grows, then this indicates an imminent trend change, as the bears are gaining strength.

Indices Need Confirmation

Dow believed that with a trend reversal, you always need to wait for the confirmation of other indices. The signals of all indicators must match. If the signals don’t match then the trend reversal is false.

Today, traders have access to convenient indicators that show oversold and overbought levels, such as the Relative Strength Index (RSI). If you noticed that the highs and lows of an uptrend began to decline (or rise for a downtrend) then you should check the RSI indicator to confirm this signal.

Conclusion

Charles Dow laid the foundation for technical analysis and for understanding the influence of traders' sentiments on the market. It was he who outlined the basics of determining a trend by higher highs and lower lows.

The Dow Forex Theory is not a strategy and will not help you accurately determine the future development of the market. Nevertheless, an understanding of the concepts of his theory will help you understand how the market works, how to read trends, and how to understand signals. Taking the first steps in any field is worth starting with the basics. For Forex, these basics lie precisely in the Dow theory.

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