Trend Analysis: Basics of the Dow Theory
principles of the Dow Theory were used only for the American indices created by Charles Dow: Transportation and Industrial. Most of them, however, can be successfully applied to the foreign exchange market.
Indices discount everything. According to Charles Dow any factor which influences demand and supply will be reflected in the index. These factors cannot be foreseen but nevertheless they are taken into account by the market and reflect index behaviour.
There are three movements on the market. Uptrend is characterised by the fact that every following top is higher then the previous one and every next bottom is higher then the previous one. Downtrend is characterised by the fact that every following top is lower than the previous one and every bottom is lower than the preceding one. When the market is in the flat position every next move (up or down) is approximately at the same level as the preceding one:
Dow classified market trends as follows:
1. primary trend (it is called a broad one and lasts from anything less than one year up to several years);
2. secondary trend (it lasts from three weeks to three months and is considered as a correcting trend to the primary one. These in-between rebounds are one-two thirds (or even half) of the range prices move during the primary trend);
3. daily trend (a short-term movement within the secondary trend, which has very little long-term forecasting value).
Another classification was suggested by Thomas DeMark:
1. short-term trend (if the price has moved less than 5%);
2. mid-term trend (if more than 5% but less than 15%);
3. long-term trend (if more than 15%).
DeMark designed a forecasting method to predict the beginning of a trend, both mid-term and long-term. The method is based on the specially designed coefficients.
The primary trend has three phases. During the first phase all unfavourable market information has been discounted by the market and the far-sighted and better informed traders start to buy. The second phase starts when the traders who do technical analysis enter the market. Once all economic data becomes more favourable, the third, final phase begins, which is characterised by high activity on the market supported by the mass media and optimistic economic forecasts in the newspapers and on TV. Despite the positive sentiment, the final phase is the first sign that the prevailing trend is about to end.
Indices must confirm each other in order for the signal to have authority (referred to Industrial and Rail (or Transport) indices). Charles Dow said that any significant uptrend or downtrend signal on the market must be considered together in the Industrial and Rail indices. If we applied this principle now on the basis of modern technical analysis, it would mean that a signal from one technical indicator must be confirmed by a signal from another technical indicator.
Trade volume must confirm the prevailing trend. If prices move in accordance with the prevailing trend, it increases the volume and inversely, when there is a rebound, volume decreases.
The primary trend remains intact until a change in that trend has been given by the theory. The last major signal remains in force until a new signal develops. Many analysts believe that a bull market must always be moving to new highs. However, the market can undergo extended periods of sideways or lackluster trading without the primary trend changing. If the last major signal under the theory is bullish, the primary bull market trend remains in force until a bear market signal is given.