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THE DOW THEORY PRINCIPLES

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By nassif (http://www.trading-mindset.com/index.php/author/nassif-guernikakogmail-com/) January 9, 2017 (http://www.trading-

The Dow Theory is created by Charles Dow, he was a journalist, and a Co-founder of Dow Jones
company, he made lot research about humanemotions and behaviors in the market,he is
considered by many as the father of technical analysis, because he was the one who changed
completely the way people operate in the market, by developing series of principals to
understand the market behavior and predict the future movement of financial markets,in this
article we will learn about the principals of the Dow theory,and how Charles Dow perceive the
market ?the most important principals of the Dow Theory are :

-The price discounts every thing .

-The market has three trends .

-The averages must confirm each other .

-Each volume must confirm the trend .

-Trends are always in motion .

We will talk about each of these principals in details,to understand in depth those principals and
apply them in our technical analysis.the first principal in the Dow Theory is that The price
discounts every thing,that means that price determines the future movement of the market,
Charles Dow says that the most important is the price,we dont have to know about the
fundamentals,we dont have to know if a company is well managed or not,because we can know
every thing from charts,there are some fundamental information that influence the market,but it
got factored in really very fast, so according to Charles Dow,the most important is the price
action, because it is the only way that allows traders to analyse the human behavior in the
market,and predict with high probability the future movement of price.in other words,we can
easily get information about what we need to know in the market by just looking at the price
action.

There are three trends in any given time :

The market has three trends that are working together in any given time, and those three trends
are the primary trend, the secondary trend, and the minor trend.and in any chart,and any given
time, those trends are at play and are working together, let’s try to explain them in detail. the
primary trend is the big picture trend, it is the major trend in the market,this trend last for at least
one year or more,it is the big picture of the market, we can realize if the market is up or down just
from the first look at the chart. see the illustration below :

In this monthly chart,the primary trend is down from the year of 2014 to 2017, and according to
Dow theory,we have to trade in the direction of the primary trend,so if you trade this market, and
you want to apply the Dow theory principles,you have to think of selling that market if there is a
clear setup.because price action says that the market is down.
Look at below another illustration of a primary trend,the big picture of the market tells us that the
market is up.

In this monthly chart, the primary trend is up from 2009 to 2017,so according to Dow theory,
traders have to trade with the primary direction of the market, if you trade this market, you have
to think of buying if there is a clear setup ,don’t try to trade against the market.

The second level of trends is known as the secondary trend,it is called the intermediate trend as
well,this trend is going to be little bit smaller and it can last a few weeks up to six or nine
months,the intermediate trend reacts to the primary trend, sometimes it is moving to the same
direction of the primary trend, and sometimes ,it is moving against the direction of the primary
trend.look at the illustration below to understand exactly what Charles Dow wants to mean by a
secondary trend.

As you see in the chart above,the primary trend is the red line, it is the big picture of the market ,
so this market is up because the primary trend is up, the secondary trend or the intermediate
trend is the one marked with grey color, it reacts to the primary trend,sometimes it is moving with
the direction of the market, sometimes it is moving against the market.it is always reacting to the
primary trend .

The third trend in the Dow Theory is the minor trend,it is functionally going to work relative to the
intermediate trend,the same way that the intermediate trend works relatively to the primary trend
.minor trend is going to be a small moves up and down that reacts to the intermediate trend,it can
last few days up to few weeks. let’s look at the illustration below to understand what Charles Dow
means by Minor trend :

Let me give you a little analogy that Charles Dow used to to give to help you understand what
does he mean by those three levels in the market.according to Charles Dow, levels of the trend
are a lot like the waves of the ocean,the tide comes in and it comes out,and that’s the primary
movement of the Ocean,in the Forex market the primary movement would be kind of the primary
trend.the secondary level of the Ocean would be the waves that you see in the ocean, you got
the waves that are going up and down,and if the tides come in , the waves are coming with it, but
the waves are still going up and down.so the same thing for the intermediate trend in relationship
to the primary trend in the market.the intermediate trend is always in movements up and down,
but it is following the primary trend.

The third level of the market is the minor trend,Charles Dow says that the minor level is like the
ripples on top of the waves,on top of the tides, and on top of the ocean.so the tide comes in and
goes out but doesn’t supersede the waves,the waves go up and down, and you got little ripples
on the waves that are going up and down, they ride with the waves,that ride with tides, and so the
minor level is riding with the intermediate level, and with the primary level.maybe this analogy
could give a pictorial idea of what Charles do means by these three levels of the market and how
they interact with each other .there are traders who use other terms such as,short term trend,
intermediate term trend, and long term trend.the terms are different but the meaning is the same .

Trend has three phases

The market has three phases, the accumulation phase, the public participation phase, and the
distribution phase.it is very important to know about the market phases,because there are lot of
traders who make trading decisions in the market,but they have no idea about what the market is
doing.if you understand the three phases of the market, you will understand how the market
moves, and when to take trades and when to stay away.so let’s start by the first phase, which is
the accumulation phase .

In an uptrend,the first movements of price is referred to as the accumulation phase,it is the point
where investors, and big institutions make their buying decisions,this phase it is very difficult to
trade, because big institution try to accumulate enough money to push the market to go up,so
they make lot of tricks,such as false breakouts,hitting stops,because they need quantities to go
up.the market behavior in this phase is always difficult to anticipate. because the market stops
trending, and it gets ready to change direction and go up.look at the illustration below to
understand how an accumulation phase looks like .

As you see in the chart above,the market was down, and it stopped trending down,so it was in a
consolidation phase, it is very difficult to trade in consolidation phase,because market
makers,and big institution look for enough quantities to make the market goes up.as you see,
there was a trick before that the market goes up,big institution makes a false breakout to trick
traders who catch the beginning of an uptrend.after that the market goes up.
the Public participation phase : in this phase, investors, and traders, participate in the market,
because they see that the market breaks out from the consolidation phase, and it is going to go
up,so they participate to establish an uptrend, this phase is characterized by a large price
movement,because all participants feel good about the market, and positive emotions drive
participants to push the market to go up.look at the illustration below to see how the market goes
up after the accumulation phase.

As you see the market was trending after the accumulation phase,because all participants know
that the market has changed its direction.it is called public phase, because all participants take
part in establishing this trend.

the distribution phase : it is when the participants take their profits,so the market stops moving
up, you can notice that the trend becomes less powerful,and the probability of a downtrend is
possible.so in this case new buyers will be tricked in the market , because they made their buying
decisions in a distribution phase.that’s what explains why you look at an uptrend that takes place,
but immediately when you make your trade, the trend changes direction, it is not because the
broker is trading against you, it is just because you don’t know that you are in a distribution
phase,where you shouldn’t buy the market. look at an illustration of a distribution phase below :

If the market was trending up, after that it stops trending, and becomes a sideways market, you
have to stop thinking of buying the market, because you need to know if the market will break the
consolidation phase,and reverse,or it will break the consolidation phase to continue in its
direction. the bottom line,don’t trade when the market is consolidating.

Look at in the illustration below to see how the market functions by respecting the three
phases,the accumulation phase, the public participation phase,and the distribution phase.

The same thing you can apply in case of a down trend, because it starts with an uptrend, then the
market consolidates to take profits, and then changes direction.so, if you are in a downtrend you
can apply the same principles.

Averages must confirm each other

Charles Dow was talking about the stock market, and he believed that a trend reversal cannot be
confirmed if there is no agreement between the both index (the Dow industrial, and the Rail
average).if the market is up that means that the economy is going fine, the primary trend of a
stock gives an indication of the economy’s situation, but if the both index goes in an opposite
direction there will be no way to predict the market.

Market averages can be viewed in many ways,in the Forex market, we can talk about the
correlation between pairs,in the future market, we can talk about the correlation between future
contract,iam not going to get into in-depth, but there should be a certain amount of cooperation
between the markets that affect one an other .

Volume must confirm the trend

In technical trading, there are two things that you have to focus on ,the price action of a stock,and
the volume, i mean how many shares have been traded,the Dow Theory goes like this,volumes
should be moving in the direction of the trend that is happening, if people are buying,we should
see an increase in volume,the same thing we can say if people are selling .volume is assumed to
move in the direction of the masses,a weak volume indicates a weak trend, and a strong volume
indicates a strong trend. Volume is used in the stock market, and it is a critical technical tool for
investors, but we cant use it in the Forex market, because it is a very large market, and it is
difficult to know how much quantities are traded in every single moment.

Trends seem to be in motion

A trend is assumed to be in effect until it gives define signals that it has reversed,the principal
here is to stay with the trend as much as possible,professional traders say trend is your
friend,and the Dow theory says the same thing about trends, a trend is your friend until it is given
a define signal that the trend has reversed.trends are always in motion, and they tend to stay in
motions .

Dow theory is not complicated,it is one of the basics that you have to learn to understand the
market structure, and how financial markets move,professional traders know about the Dow
theory, and if you want to be a professional trader you have to learn about it, and apply these
principles in your technical analysis.that will help you go to the next level with your trading
business.
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