Thu Oct 27, 2016 11:34 am
Dow Theory Concepts in Forex
There’s hardly a trader, whether short term or long term, who doesn’t rely, in some form or another, on technical analysis. Yet many don’t know that the backstory behind what we today refer to as technical analysis is actually a collection of ideas on trading stocks. Some of those ideas are, in fact, more than a hundred years old; they are referred to collectively as Dow Theory. Going into the source, the so-called genesis of technical analysis can provide valuable lessons for a trader, even today and even in Forex. In this article I will go into some basic concepts of Dow Theory and offer my personal takeaways from it.
First, though, the backstory. The Dow Theory is named after Charles Dow, a financial journalist and one of the founders of the world-renowned Wall Street Journal. Dow had written a series of articles on his theories and concepts on market behavior, pricing and patterns for the Wall Street Journal. Those ideas were later developed further, refined and enhanced by followers such as William P. Hamilton, Robert Rhea and Richard Russell. The collection of ideas known as the Dow Theory therefor, encompasses concepts from Dow and his followers.
Dow Theory Concepts
With that brief history of the Dow Theory behind us, it’s time to get into the meat and focus on some key concepts and how they could be implemented when trading Forex.I like to think of the Dow Theory as having two pillars—one theoretical, the other practical. The theoretical concepts focus on how to approach the market, the so-called theory behind trading.
The practical ideas are focused on things such as rising tops and bottoms, which confirm a bullish trend, and/or rising volumes, which confirms a trend’s strength. Since most practical ideas belong to basic technical analysis such as stretching a trend line, I will focus on the theoretical side which is often overlooked by traders.Combining the two pillars should give the trader the proper approach and the necessary tools to beat the market.
The Dow theoretical side focuses on the benefits of the bigger picture. In other words, it focuses on what the broad market is doing rather than a specific asset or security or, in our case, a specific pair. Why?
Over the longer term, the broad market cannot be manipulated by any one player. It is true that over short durations, the broad market can be manipulated, but unlike a stock or a security, over the long haul there is no one factor with enough liquidity to manipulate the long term trend. That means that in order to profit one must first gauge the long term trend of the broad market, and only then can one make a decision on the next trade.
Moreover, according to the Dow Theory, the broad market prices all the knowns and even the potential unknowns that have a higher probability of occurring. In other words, the broad market is so big and diversified that the current trend and price behavior prices all the known positive and negative information as well as all that market participants believe could happen.
Dow in Forex
Although the Dow Theory was initially designed for analyzing stocks, the concepts stated above can provide some powerful insights into the Forex markets. If we refine the two concepts we get one clear idea; that is the best way to predict markets is to focus on the big picture and that means focusing on the long term and focusing on the broad market rather than a signal pair.
That means that focusing on the long term trend over months, and even years, can yield much better results than focusing on shorter durations. Moreover, in a more practical sense, longer duration charts tend to be easier to analyze with support, resistance and trends much easier to define. Personally, it is one of the key reasons that I prefer long term trades. Of course, short term traders can be highly lucrative and successful as well, but focusing on the long term trend is essential for crafting a strategy that could work over the long run. It allows you to identify areas of high volatility, areas where a pair is destined to have resistance, or areas where short term support can be broken.
Another important takeaway is focusing on the broad market. How does that come to play in Forex? It means that you should always aspire to analyze the big trend. In practical terms, it means, for example, that you should always analyze the Dollar Index before trading a dollar pair, to figure out the long term trend on the dollar. It also means that, if you trade a low liquidity pair such as the USD/BRL, you should first identify the overall trend in the FX market, risk on or risk off.
As seen in the sample below, the EURUSD is trending higher which means a bearish Dollar. But on the other hand in the second chart , the Dollar Index which represents the Dollar against a basket of currencies, is trending higher as well suggesting the exact opposite, a bullish dollar. Since Dollar index represents the big picture for the Dollar it is the one we should relate to when determining the long term trend.
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The Bottom Line
Of course, there are many more takeaways and more layers to the Dow Theory and it is always a good idea to go over the original books and learn from the source, whether it’s the articles by Charles Dow himself or The Stock Market Barometer written by William P. Hamilton and The Dow Theory by Robert Rhea. But, as an experienced trader, through the years I have found that the best takeaway from the Dow Theory is that its emphasis on the big picture improves your chances to avoid manipulation and areas of unexpected market reactions which, in turn, makes a strategy more successful. It doesn’t mean that you have to trade only over the long term but it does mean that you have to first figure out the long term before anything else.
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