Theories such as Fibonacci, Elliot Wave and Gann are supposed to scientifically predict market movements in advance but if they really were scientific, they would win all of the time and none of them do – there loved by the far out investment community but they are not scientific and they will lose you money.
Dow theory is so important because it helps you gain a greater insight into market movement and help you lock into and hold trends.
The Origins of Dow Theory
In 1901,Charles H. Dow compared the stock market, to the tides of the ocean and the quote below introduced the theory which carries his name:
"A person watching the tide coming in and who wishes to know
the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market."
Trading the Odds the Key to Making Currency Trading Profits
Like the waves of the ocean, we all know that tides ebb and flow but we don't know exactly how they will ebb and flow and where the wave will stop Exactly – We do know however the tide is coming in though. Just as waves don't move to a scientific theory, neither do currency markets however they do move to a pattern. In currency trading to win you need to spot the patterns with the best chance of success, and trade them and if you do this correctly you will make profits.
Dow Theory Revised
Dow theory is now over a century old but Dow theory remains as valid today as it ever was. Dow theory is a technical theory but its roots lie in human psychology and of course this has never changed. Dow theory was later developed by Rhea and Hamilton, who refined it and bought it to a wider audience and it remains one of the best ways of understanding Forex market movement.
The Three Phases of a Trend Defined
Dow and Hamilton identified three types of price movements:
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Primary Movements
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Secondary Movements
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Daily Fluctuations
Primary Movements
Primary moves generally last from a few months to a few years in length.
These primary moves represent the broad underlying trend of the market which can be seen on any chart.
Secondary Movements
Secondary Movements, also known as reaction movements generally last a few weeks to a few months - and move counter to the primary trend and are created by various events such as central banks and geo political events.
Daily Fluctuations
Daily fluctuations can move with or against the primary trend – and they generally last from a few hours to a few days but in most instances no more than a week. These daily fluctuations, are really random and are simply the noise of the market.
Now let's look at how trends develop and end. Hamilton identified three specific phases, in both primary bull markets, and primary bear markets. These stages are a reflection of the psychological state of the market and they are reflected time and time again in chart patterns.
A primary bull market was defined as: a sustained advance, marked by improving fundamentals, and investor confidence - a primary bear market is the exact mirror image of a primary bull market. In both bull bear markets, there will always be secondary movements, that run counter to the major trend. While Dow theory was developed for stocks, the format works in any market – here is a summary:
Primary Bull Market: Stage 1 – Accumulation
Hamilton concluded that the initial stages of a bull market were indistinguishable from the last reaction rally, of a bear market. Pessimism, which was excessive at the end of the bear market will still be present at the start of a new bull market.
It's at this stage, that savvy traders start to accumulate positions - as the market is cheap or below fair value, and now offers good value. In the first stage of a bull market, prices begin to find a bottom, and firm up and base to move higher When the price first starts to rise, there is scepticism that a bull market is emerging.
After the first leg peaks, and starts to head back down, the bearish view of the majority seems to be confirmed.
It's at this stage that careful analysis is needed, with Dow Theory - to determine if the decline is a secondary movement (a correction of the first leg up). If it's a secondary move, a low forms above the previous low, a period of low volatility will be present as the market firms up - and the bull market finally starts to unfold.
When the previous peak is surpassed, the beginning of the second leg forms and we have confirmation that there truly is a bull market.
Primary Bull Market: Stage 2 - Big Move
The second stage of a primary bull market is normally the longest - and represents an easily identifiable trend clearly indicated with any form of currency technical analysis. This period sees a sustained advance in price an an up trend can clearly be seen on the chart it's a period marked by improving fundamentals, and increasing confidence amongst investors who want to get in on the trend..
Primary Bull Market: Stage 3 – Excess
The third stage of a primary bull market is marked by excessive optimism, and excessive speculation and sees greed come to the fore.
During this third and final stage, the public are heavily involved on the long side. Prices are being pushed by investor greed and we see the bullish sentiment then peak.
Primary Bear Market: Stage 1 – Distribution
Accumulation is the hallmark of the first stage of a primary bull market, and distribution marks the beginning of a bear market, as prices are now over valued and smart people begin to realize this and start to trade in a contrary fashion to the trend.
The public are still heavy buyers at the top however as the fundamentals appear to be bullish and this is reflected in the news and media but this is how every major bull market ends with an extreme in bullish sentiment. Prices start to fall from the highs but most investors remain bullish and they are about to lose their money.
After a moderate decline, there is a reaction rally, (secondary move) which retraces a portion of the decline but doesn't make a new high
Hamilton observed that reaction rallies during bear markets were normally swift and sharp pops to the upside. This quick recovery movement gives confidence to the bulls again however, the reaction high of the secondary move will form - and will be lower than the previous high.
After making a lower high, a break below the previous low, will confirm the bull move is over.
The exact opposite happens in a bear market and we run through the phases again but in reverse.
Final Words
Dow Theory remains as valid today as it ever was because trends still start and end in the same way as they did when the theory was written and if you understand it not only will you understand trend following better, you will make bigger profits from your trading and remain one step of the emotional crowd – If you want to enjoy bigger currency trading profits Dow theory can help you achieve just that.
