Dow Theory for Currency Traders

I think the one of the more influential set of theories you need to understand in order to trade is Dow Theory. Well over a hundred years ago Charles Dow developed a set of indexes that he used to monitor stocks in similar categories: industrials, utilities and railroads. Aside from a name change of rail roads to the Dow Jones Transport Index, these indexes are still in use today.

I think the one of the more influential set of theories you need to understand in order to trade is Dow Theory. Well over a hundred years ago Charles Dow developed a set of indexes that he used to monitor stocks in similar categories: industrials, utilities and railroads. Aside from a name change of rail roads to the Dow Jones Transport Index, these indexes are still in use today.

Charles Dow also passed on to a number of his students a series of theories about how to read the markets. Later these theories were dubbed “Dow Theory”. Dow Theory pretty much underpins most of the thinking behind modern technical analysis as we know it today. Once you understand Dow theory you are better able to put just about any of the newer approaches to trading in context.

In Dow theory there as six important tenets that help us clarify price action in the market. The following sections will look at each of his tenets.

Tenet #1: The Average Discounts Everything (except acts of God)
Charles Dow recognized that a number of different players are participating in the market, ranging from short term speculators, long term investors, specialists, insiders, etc and all their expectations about the future of the market are built into the current price. In other words the price has already “discounted” the future expectations of market participants. Unfortunately in trying to understand what expectations are currently built into the price of a stock is no easy feat, because in Dow’s time his markets where highly manipulated by specialists and insiders. To combat this Dow developed a series of averages for each sector of the market so he could more easily see the difference between sector performance and the performance of an individual stock and gave him clues if the stock was being manipulated or if the stock was a market leader. Finally, Dow recognized the effect of “black swans” as we know it today. It is basically impossible for the price to build in unknowable events before the happen (like subprime meltdowns, Russian credit defaults, 911, etc). Therefore in these kind of events the price will react very strongly.

For a theory that is over a hundred years old – this is incredibly incisive. It is no wonder that many traders still think it is cool to classify themselves as “Students of Charles Dow”. When it comes to applying this to currency markets the lessons are all the same. You should try and be aware of what expectations are built into the price of a currency pair. You should always be looking at the US Dollar index when analyzing currencies, because it helps you separate price action unique to a pair from general performance of the dollar. And finally you need to be aware that an act of god can easily come along and upset the apple cart at any time.

Tenet #2: There are three classifications of trend – primary trends, secondary swings and minor day-to-day fluctuations
I have written another blog posting on this one. You can find it here.

Tenet #3: The principle of confirmation
Most technical analysts talk about confirmation in terms of finding two or more indicators that agree with one another. This is a misinterpretation of the original intent of Dow’s theories. Dow was more interested in intermarket relationships as a way of confirming the primary trend’s direction. For a bull or a bear market to exist Dow felt that two of the three major averages (industrials, utilities and transports) must confirm the direction.

Application of the principle of confirmation to the currency markets is slightly different. On a simplistic level you should look at how a currency is performing across two or more pairs to get a sense of the major direction of the trend. However, one can also take this to another level and look at how the major markets are related to one another and build a solid understanding of the broader macro picture.

Tenet #4: Volume goes with the trend
Dow recognized that in a trending market the volume must increase as the trend develops as this indicates interest in the market and a growing number of participants.

Some technical analysts take this a step further and decree that declining volume means the trend is a sign of a weakening trend. Dow never pushed that theory. Declining volume only means that there is less liquidity in the market and things are likely to get more volatile.

Due to the decentralized nature of the currency markets there are no sound indicators of volume. Some Forex brokers provide volume information, but really this is just a count of the number of ticks and not a true indicator of volume.

For a better indicator of volume you can look at the currency futures market. However, I find that looking at open interest is a much better indicator of trend strength as volume only shows high levels of participation in the market for the day and can be easily biased by heavy day trading activity. Open interest on the other hand shows how many positions are still open at the end of the day. As a result it provides a much better indicator of ongoing strength in the trend.

Tenet #5: Only closing prices are used
Dow had a strong belief that the closing price each day is the most important price as professional day traders prefer to liquidate their positions at the end of the day and not carry positions overnight.

Application of this theory to the currency market is not so easy as it is a 24 hour market. I wish I could give some good advice on how to set you charts up to reflect closing prices for the major markets (like the NY close), but the overlapping trading days in the different timezones make this nonsensical.

Tenet #6: The primary trend persists
Dow operated on the premise that the primary trend should be assumed to continue in effect until it reversal has been signaled.

The persistence of trends is an important feature of the market, because without it we are doomed never to make money from trading. The problem is knowing when the reversal has been signaled and a regime shift is underway. It is the ability to spot the difference between temporary volatility and the genuine end of the trend is one of the hallmarks of a great trader (something which I am not).

Macrotactics is a blog devoted to recording a part time trader's journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has become... More