Dow Theory is considered one of the foremost authorities in the study of basic market philosophy. In fact, technical analysis as we know it, finds its origin in the theory that was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 till 1902 and articulated by his followers and associates such as Robert Rhea (The Dow Theory, 1932).
Dow essentially believed that asset values reflected the underlying fundamentals and business conditions. By analyzing those conditions and factors, one can identify the direction of major market trends, in Forex and other asset classes such as equities and commodities.
The following is a list of the six basic tenets of the Dow Theory:
1. Market Price Movements
Primary movements can commonly be identified in terms of "bull" or "bear" market. In other words, it’s the general trend of the overall market. Temporary fluctuations in pricing are known as Secondary Movements. These are shorter in terms of time period and typically run in the opposite direction as Primary Movements. For instance, a secondary movement during a bullish phase would be referred to as market correction. Daily fluctuations vary greatly and can be caused by a number of factors ranging from fundamentals such as macroeconomic news to technical factors such as overbought conditions. It’s important to note that the forex market continues to move in the same overall direction until or unless a primary trend change takes place.
2.Three Phases of Primary Trends
- A: Accumulation - characterized by informed investors entering the market
- B: Public Participation - : revival of massive public interest in the concerned currency pair. This phase continues until rampant speculation occurs.
- C: Excess - : At this point, the smart ‘first-mover’ investors begin to distribute their holdings into the market. A ‘bear’ market operates inverse to a “bull” market are characterized by the phases Distribution, Big move and Despair that witness selling instead of buying.
3. Market Discounts
All knowledge Dow asserted that the market takes into account all information – past, present and the future and reflects the same in the price behavior.
4. Market Indexes Confirm Each Other
The transition of a bull into a bear market or vice-versa, is possible only when more than one index shows similar trends. Primary trends, either up or down, are the overall direction of all markets reflecting economic conditions. For instance, if two USD pairs (where USD is a quote or counter currency in either pair) are in conflict, there is likely no clear trend reversal.
5.Volume Confirms the Trend
Volume increases when prices move in the direction of the trend and decreases when prices moves in the opposite direction. For instance, an uptrend shows strength when volume increases because traders are betting more on the upward momentum continuing. However, if the volume is weak on the up move, it means ‘buying’ of assets is dissipating. If buyers turn into sellers, the market will not continue its upward trend.
6. Trend Reverses Only with Evidence
Trend reversal will only take place in the presence of concrete evidence. For instance, if the USD/JPY pair is moving downward but the unemployment index has released good news, the downward movement cannot be termed a trend reversal
In summary, Dow Theory is a set of general guidelines and principles for understanding technical analysis and coupled with fundamental understanding of assets and pricing, predicting basic price movements. It forms the very basis for technical analysis as we know it today.