Demystifying The Dow Theory

In the previous post, we looked at candlesticks and its inventor Homma Munehisa. If Homma is to be called the father of Japanese technical analysis in Japan, there is Charles Dow who should be called as the father of Western technical analysis.

Finding Patterns in Chaos

When we hear the name Dow, we immediately think of Dow Jones Industrial Average. It’s being mentioned every day in the news together with other indices like the S&P 500. If you know a bit more about Charles Dow, you might think of The Wall Street Journal that he started with a fellow reporter, Edward Jones in 1889. But these are not the only contributions he made to the world of finance. And among all the contributions he made, what matters the most to us, forex traders is The Dow Theory.

Dow Theory is a set of tenets that describe market trends and how they typically behave. In his time at The Wall Street Journal, he carefully speculated his Dow Jones Rail Average and Dow Jones Industrial Average for a long time and started to notice patterns emerging in the movement of the indices. Yes, we can say Charles Dow had ‘a beautiful mind moment’ hit him.

Even though his speculation was mainly based on his indices and on top of that his time was more than 100 years ago, I dare say that it is still relevant to any asset class today.

4 out of 6 Basic Tenets of Dow Theory

As already mentioned above, this theory is based on stock market indices movement, therefore some of its statement is not applicable to forex. I’ll be bold here and introduce only 4 of the tenets which are relevant to the forex market. You are welcome to do your own research about the other two, but these two that I’ll be omitting here are difficult to apply to the forex market.

1. The market has three movements: main movement, medium swing, short swing

The thick red and green lines on the chart is a major trend. If we focus on the green uptrend part, we can see that it’s going up (blue line) zigzagging. Even within a straight blue line, there are smaller zigzags. We can consider thick red and green lines as the main movement, the blue line as medium swing, and zigzags within one straight blue line as short swing.

In traditional Dow Theory, what he meant by the main movement is a trend that lasts more than a year. But this logic can be applied to any time chart due to the fractal nature of the market movement.

Below is a 1hour chart, and a small part of the above daily chart.

Again we can see the main movement, medium swing, short swing. Do you know what part of the daily chart is this?

It is the yellow highlighted part from the above daily chart that we have already seen. So just one medium swing movement in the daily chart can have main, medium, and short if we change it to an hourly chart. What I’m trying to say is the decision on what’s the main trend, medium, and short really depends on our perspectives. If we are looking at 5 mins chart, there will also be the main, medium, and short trend there.

How does it help us when we’re trading? By zooming out and looking at the chart in this way will give us an understanding of where we are at the moment. Are we entering short to ride a medium swing when the main trend is up or are we following the main uptrend and find a nice place to enter long? It’s up to our strategy, but the difference between knowing where you stand in relation to the major trend and just focusing on trees without seeing the forest is big.

2. Market trends have three phases

This tenet is very similar to Product Life Cycle in marketing. Below is the chart that shows search keyword frequencies of “fidget spinner” during 2017. These kinds of information are readily available in Google Trends, and when I’m bored I just randomly look at trends of some words, and it always amazes me. And yes, I’m one of those who bought that premium version of fidget spinner in shiny metal. 

Around early 2017, fidget spinner wasn’t that famous, but still, some cool kids were playing around with these, so-called early-adopters. Just like smart money buys at the accumulation phase. Then it started to pick up, and suddenly more and more kids around us are with a fidget spinner. Public participation phase. Then the cool kids who originally started to play with fidget spinners before anyone else became bored of it, and it was not cool anymore. So they move to something else. At this stage, fidget spinners were virtually everywhere. Every corner shop, or big supermarket, you name it. This is a clear sign of market fatigue. In trading, when everyone is talking about “it’s rising, rising”, it’s a sign that it might be a distribution phase. Finally, the fad is gone, and sales, interest, everything is a downtrend.

The lesson we can take away from this is that we want to be a trend-follower. Let’s be honest, we are not Warren Buffet. When we don’t know where the market is moving, it’s safer to wait until a clear trend shows up and ride the tide. There’s nothing to be ashamed of if you are not a trend-setter. What’s more important for us is a safe bet. I wasn’t one of those cool kids in school anyway.

3. The market discounts everything

 When I first saw the above sentence, it really confused me. Even though I’m writing this post in English, and been living in English-speaking country for a while, when I hear a word “discount” all I can think of is “discount” as in deduction from the usual price. You know, “50% off, BIG DISCOUNT!”, that kind of “discount”.
But the “discount” used in the above sentence has a different connotation. Its meaning is closer to “take into consideration”. To be honest, I have never heard word “discount” used in this sense, but looking at Marriam-Webster, apparently, there’s a definition of “discount” as a verb which reads “take in to account (something, such as future event) in present calculations or planning.
What does Dow mean by this? In a simple sentence, it means that everything there is to know about the market is already reflected in the price movement. All the information available, all the fundamentals such as interest rates, all the sentiment, expectations, hopes, fears are already there in the market price we are seeing right now.
This principle is a strong support statement for technical analysis. The above sentence alone can start a fierce debate between fundamentalist and technicians. Fundamentalists put importance in reading the macroeconomic environment, while technicians put more importance in analysing the chart patterns. Technicians armed with Dow’s statement can boldly say “all the fundamentals are already priced in, we just have to read charts carefully”.
I’m more towards technical analysis. I believe market sentiment plays a crucial role in moving the price up and down, and fundamental analysis doesn’t put much emphasis on this aspect. But that doesn’t mean I ignore fundamentals altogether. I’ll write up a post someday about fundamental analysis.

4. Trends exist until definitive signals prove that they have ended

We can categorise any market movements into three categories: uptrend, downtrend, and no-trend (range). Uptrend when the market is moving up, downtrend when the market is moving down, range when the market is moving up and down within a certain range and go sideways. What the above tenet is telling us is that the market is likely to continue the same movement. If it is an uptrend, it will more likely to go up, if the trend is down, it will more likely to go down, if the market is in range, it will more likely continue to stay in range. 

This tenet reminds me of Newton’s First Law of Motion. According to Newton, an object remains in the same state of motion unless a resultant force acts on it. This tendency of an object to continue in its current state is called inertia. Thus, the law is also called The Law of Inertia. 

This is all useful, but the question is how do we know when a trend is finished? What is a definitive signal? Let’s take a look at an example of an uptrend and see what is the condition of a trend, and what makes it disqualified as a trend.

 From the first tenet, we already saw the market is moving in wake-like motion. In order to be qualified as an uptrend, ups of the wave should be higher than the last up of the wave, and downs of the wave also should be higher than the last down of the wave. As long as this continues, we can say it is still in an uptrend. From the above chart, after a long rally of the uptrend, there comes up failed to go higher than the last up. At this point, we can say that the uptrend is now ended. It doesn’t qualify as a downtrend yet, though. Then at what point can we be sure that this has changed to a downtrend? It is when down of the wave goes lower than the down that has happened just before the highest up. The principle is the same for a downtrend, only in the opposite way.

One thing to keep in mind is that Dow Theory is not a law that the market strictly follow, it is more like a guideline for us traders. Sometimes even when it looks like the market trend has turned its direction, it turns out to be not. It’s a matter of probability. 

 

Thank you for reading. Through this post, we looked at the very basics of Dow Theory. In the next post, we will take a look at how to draw horizontal lines on the chart and what do they mean.