Dow theory: what it is, basic principles, how it works in Forex trading and how to use it

The Dow theory, which allows traders to study market prices, is called one of the building blocks of technical analysis. Charles Dow developed these ideas, and after he passed away, they were all put together into a single theory named after him. The Dow theory became a game-changer because it showed that the financial world worked systematically, not randomly. Charles Dow affirmed that trends were developing over time. Even though these ideas were formulated in the late 1800s, they're still relevant today. The Dow approach helps traders determine the market trends and make smarter decisions to profit.

In this article, we'll discuss the main parts of the Dow theory, how it works, and how to use it.

Meaning

The Dow theory suggests that all the information you need to forecast future prices is already shown on price charts. Journalist Charles Dow challenged the common idea at the time that traders had to depend solely on economic news and other outside factors to succeed. Instead, he proved that market participants could comprehend where the prices were headed by closely looking at chart patterns and movements. This was a revolutionary approach then, and today, Dow's ideas are continuously studied and implemented.

The Dow theory's goal

Dow developed a set of six fundamental principles, known as tenets, to help traders and investors understand and analyse the stock market behaviour. Although originally developed for the stock market, Dow Theory’s principles are universally applicable across markets, including Forex. These principles act as a framework for recognising trends and patterns in market movements.

Principles

Charles Dow's theory is built on six key principles. Let's break them down one by one with real-life examples.

Market discounts everything.

Any factor that can influence supply or demand in the market will be reflected in the dynamics of the asset's value. For example, if traders anticipate that a country will raise interest rates, traders think this will make the country's currency more valuable and start buying it ahead of the announcement. Therefore, even before the official announcement, the currency's price is likely to start rising in the Forex market.

There are three primary types of market trends.

Charles Dow figured out three types of trends: primary, secondary, and minor.

The primary trend usually lasts for over a year. It is called the ‘bear market’ when prices decrease and the ‘bull market’ when prices rise. The secondary trend is like a bit of correction happening within the primary one. It usually lasts from two weeks to a month or longer. Lastly, we have minor fluctuations, the third type of trend. These are short-term movements that are usually considered to be part of the secondary trend.

Primary trends have three phases.

1 – bull market
2 – bear market
3 – phase 1: accumulation
4 – phase 2: public participation
5 – phase 3: excess phase
6 – phase 1: distribution
7 – phase 2: public participation
8 – phase 3: panic phase

According to the Dow theory, market trends can be broken down into specific phases.

The first phase is called accumulation. This is when investors start buying or selling based on the positive or negative news they receive about the economy. Next comes the second phase, called public participation. This is when more traders jump in using technical analysis to make decisions. As the market shows more positive signs, it moves into the last stage, known as the distribution phase.

During the distribution phase, all traders become engaged, creating noticeable excitement in the market, especially when various media outlets report news. Conversely, if the public starts expressing pessimistic sentiments, it often indicates that the trend may be reversing downward.

For example, during the accumulation phase, savvy traders begin buying USDJPY at lower prices after a downtrend, anticipating a reversal. As more traders notice the upward movement and start buying, the price rises, marking the public participation phase. Finally, in the distribution phase, some traders begin selling off their positions to make a profit, potentially leading to a price correction.

Indices must confirm each other.

Charles Dow also introduced two indices: the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). He believed that every significant signal must be reflected in the values of both indices.

If the DJIA is making new highs while the DJTA is lagging, it may signal a potential divergence and the weakening of the current trend. While this perspective has evolved over time, the core principle remains. In today's context, this means that understanding of any indicator should be corroborated by another one. For instance, if we apply the concept to the Forex market, when the dollar is strengthening against the euro (with EURUSD falling) but weakening against the yen (with USDJPY also falling), it may indicate mixed signals. Traders should seek confirmation from other currency pairs before making decisions.

Volume must confirm the trend.

An increase in trading volume should occur when the price moves in the direction of the primary trend, while a decrease in volume should accompany pullbacks. For example, if the GBPUSD pair is rising and trading volume increases significantly, it suggests strong interest and reinforces the likelihood that the uptrend will continue.

Trends persist until an apparent reversal occurs.

Prices are more likely to continue in the established direction rather than reverse. If there is a deviation in quotes but no clear signal of a price reversal, this should be interpreted as a temporary correction rather than a termination of the trend.

For example, if the AUDUSD has been in a downtrend but suddenly breaks above a key resistance level with strong volume, this could indicate a potential trend reversal. Traders should look for further confirmation before taking action.

The Dow theory trading strategy

The knowledge of theoretical principles helps traders develop an effective strategy.

Here are the six steps to follow when using the Dow theory in Forex trading:

1. Identify the primary trend. Begin by analysing long-term price charts (weeks to months in the Forex market, months to years in the stock market) to determine whether the market is in an uptrend (higher highs and higher lows) or a downtrend (lower highs and lower lows).



1 – uptrend
2 – downtrend
3 – sideways trend

2. Confirm the trend. For example, in the stock market, ensure both the DJIA and the DJTA are moving in the same direction, and in the Forex market, look at related currency pairs. This confirmation strengthens the validity of the identified trend. Look for increasing trading volume in the direction of the trend. For instance, volume should rise during an uptrend as prices increase; low volume may indicate a weakening trend.
3. Monitor for secondary trends. Determine secondary trends as opportunities to enter positions at favourable prices. For example, in an uptrend, a temporary pullback can provide a buying opportunity before the primary trend resumes.
4. Look for reversal signals. Be vigilant for signs of trend weakening or reversal, such as changes in trading volume or breaks in crucial support and resistance levels. These signals can prompt adjustments to your trading positions.
5. Use technical analysis tools like moving averages, trend lines, and momentum oscillators to refine your entry and exit points. They can help confirm trends and identify potential reversals.
6. Implement risk management strategies. Use stop-loss orders to limit potential losses if the market moves against your position. Determine appropriate position sizes based on risk tolerance and market conditions to manage exposure effectively.

Example

Let's say you're analysing the EURUSD currency pair using the Dow theory:

1. You see that the price has been moving in a series of higher highs and higher lows: it rises from 1.1000 to 1.1200 (first high), then dips to 1.1100 (first low), and subsequently climbs to 1.1300 (second high).
2. According to the Dow theory, the trend is bullish and continues because the price makes higher highs and higher lows.
3. You might enter a buy position when the price breaks above the second high at 1.1300, confirming the upward trend. If the price then retraces to 1.1200 but doesn't drop below the last low of 1.1100, this reinforces the bullish trend, providing further confidence to hold the position or add to it.

Thus, you can use Charles Dow's ideas to spot a clear trend and make informed trading decisions based on price movements.

Does it work?

The Dow theory focuses on figuring out the market prices' main direction. Investors look at how they have changed over time and use helpful tools like moving averages and trendlines to see if the market is going up, down, or staying steady.

Understanding the Dow theory also helps investors manage risk effectively. For example, if you're investing during an uptrend, you can set stop-loss orders just below critical support levels, and if you're in a downtrend, you can place them just above resistance levels. This strategy is designed to limit potential losses if the market moves in the opposite direction of what you expected.

The analytical tools developed by Dow are used by traders worldwide, but his principles also face criticism from world-renowned experts. For example, John Murphy in his book 'Technical Analysis of Futures Markets: Theory and Practice', highlights one of its critical negative points: the indicators created by Dow tend to be delayed. Specifically, a buy signal typically appears in the second phase of an upward trend only after the previous intermediate peak has been surpassed, which often means that 20–25% of the trend has already transpired.

While the Dow theory allows you to recognise the trend's beginning and end fairly accurately, analysts argue that it does not adequately address the duration and intensity of forthcoming price movements.

Final thoughts

• The Dow theory serves as a 'global map' for navigating market trends, and explaining the logic behind market movements.
• According to Dow, all public and private information is already reflected in the current market prices. This means that any news or events that could impact the prices are already incorporated into them.
• The theory helps traders identify prevailing trends by categorising them into primary trends that last for a long time, secondary trends with a moderate duration, and short-lived daily fluctuations.
• While the Dow theory is valuable for trend identification, it is considered outdated in some aspects. For example, it cannot adequately address the duration and intensity of forthcoming price changes.
• When analysing the market, it is better to support Charles Dow's postulates with other practical tools.