Approaching FX using Dow Theory

Hi all,

The Master, Charles Dow and his learned disciples always said; the trend is your friend until it ends.

Each of us have our own approach to the FX Markets. From the small experience which i have gained by trading FX over the years, i have learned one important thing....the FX market is the most trendy market you can ever find. While the methods and approaches have changed as markets becomes more sophistacated, one thing has remained constant, TRENDS. Many of us has disputed on how we identify trends and approached them, while the Dow Theory has implied a very simple manner to approach trends, we just could not completely rely on it due to one huge factor....VOLUME.

There are a few questions which i would like to ask to dow theory practitioners,

1. Without the presence of volume, how do we identify a valid swing of trend or infact the trend itself? Do we just discount volume for that fact? If so, on to the next qn.

2. As the theory mentioned, an uptrend is a series of movements where price records a higher high and higher low....So we have already identified our primary trend, on an correction (secondary reaction), how and where do we find the likelyhood of a high probability entry to mark the continuation of the primary trend?

I would like to discuss this theory further but for a start, lets discuss this two questions first and as we move forward, we'll likely dig deeper into the theorems of the theory.

Please share your views.

regards,

Jest

Now i don't know about that... sounds like another forex myth!

I've writen about this before, so here it goes again:

I've recently read an article in Currency Trader magazine : www.currencytradermag.com (latest issue) (it's free) which basically disproves it. I quote:

"Nevertheless, from this longer-term
perspective, there’s no basis from which
to argue these currencies have better
trend characteristics than the representative
instruments they were tested

against" (tested against S&P 500, Boeing and 10-year T-note)

Best of luck,

Vlad

All right,

apologies, i have definitely used the wrong term to describe the FX Market. Lets get back on to the initial discussion coz what I'm hoping to read is some fruitful discussion regarding the application of the Dow Theory in the fx market.

Vlad thanks for correcting.

regards
jest

No problem, Forex Sceptic to the rescue

P.S. I've looked at yout blog, nice reading list, i've added half to my wish list. I've read Against the Gods... brilliant book! Also, well done for sept..

reliving mudbuhha's post on trading the dow theory,

Mud buddy, could you update ur charts lol, i cant see any of em. Could merlin help to magically bring the charts back?

http://www.forexfactory.com/showthread.php?t=4675



back to discussion,

Since there is not much discussion on this, i will dig deeper into the tenets and hypothesis of the Theory itself so that we could find some order in the fluctuations of the the market movements. I have found that Hamilton has made the best summarization on the basic concepts of Charles’s Dow market ideologies...it stems from 3 Elements and 5 Pillars.

The 3 Elements

Manipulation: Manipulation is possible in the day-to-day movement of the averages, and secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated.

The Averages Discount Everything: The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events {excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.

Quote

Disliked

This used to be for olden markets but now markets are much more complex and globalized, I’d reckon tracking the S&P 500, FTSE, DOW, Nikkei and Hang Seng Trends to get a clearer picture on global market health.

The Theory Is Not Infallible: The Dow Theory is not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial. The wish must never be allowed to father the thought.

The 5 pillars of the Dow Theory in Determining Price Movements.

Dow’s Three Movements: There are three movements of the averages, all of which may be in progress at one and the same time.

The first, and most important, is the primary trend: the broad upward or downward movements known as bull or bear markets, which may be of several years duration.

The second, and most deceptive movement, is the secondary reaction (intermediate trend): an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months.

The third, and usually unimportant, movement is the daily fluctuation (short term trend).

*Now we know where Dr Elder got his Triple screen system…

Primary Movements: The primary movement is the broad basic trend generally known as a bull or bear market extending over periods which have varied from less than a year to several years. The correct determination of the direction of this movement is the most important factor in successful speculation. There is no known method of forecasting the extent or duration of a primary movement.

Primary Bear Markets: A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principal phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.

“At the end of the bear period, the market seems to be immune to further bad news and pessimism. It also appears to have lost its ability to bounce back after severe declines and have every appearance of having a rasched a state of equilibrium where speculative activities are at low ebb, where offerings do little to depress prices, but where there appears to be no demand suffucient to lift quotations. Pessimism is rampant, dividends are being passed, some important companies are usually in financial difficulty. Because of all these things, stocks make a ‘line’, when this line is definitely broken on the upside, the daily fluctuation of the averages shows a tendency to work to slightly higher ground on each rally, with the ensuing declines failing to pass through the last immediate low. It is then that a speculative position on the long side is clearly indicated."

Qouted from Robert Rhea's obeservations

Primary Bull Markets: A primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years. During this time, stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity. There are three phases of a bull period: the first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporation earnings, and the third is the period when speculation is rampant and inflation apparent-a period when stocks are advanced on hopes and expectations

Secondary Reactions: For the purpose of this discussion, a secondary reaction is considered to be an important decline in a bull market or advance in a bear market, usually lasting from three weeks to as many months, during which intervals the price movement generally retraces from 33 per cent to 66 per cent of the primary price change since the termination of the last preceding secondary reaction. These reactions are frequently erroneously assumed to represent a change of primary trend, because obviously the first stage of a bull market must always coincide with a movement which might have proved to have been merely a secondary reaction in a bear market, the contra being true after the peak has been attained in a bull market.

http://img171.imageshack.us/img171/9...3trendsjy6.jpg
Figure 1

By looking at Figure 1 we could see the example of 2 out of 3 of the prevalent trends., which is the primary bull and the secondary reactions/primary swings (intermediate trend). And what I have gathered suggests that:

1. Every Secondary Reaction has the potential to turn into a Primary Bear.

2. Every Secondary Reaction and Primary Swing usually moves in 3 phases, A-B-C. See Figure 2

3. Most Secondary Reaction usually retraces to approximately 30-50% of the Primary Swing at extreme cases price will retrace al full 100% indicating dire conditions/manipulations but no real change in market fundamentals yet.

http://img155.imageshack.us/img155/7129/abchh1.jpg
Figure 2

Approaching the Dow Theory in a Technical Sense

Daily Fluctuations: Inferences drawn from one day’s movement of the averages are almost certain to be misleading and are of but little value except when “lines” are being formed. The day-to-day movement must be recorded and studied, however, because a series of charted daily movements always eventually develops into a pattern easily recognized as having a forecasting value.


Determining the Trend: Successive rallies penetrating preceding high points, with ensuing declines terminating above preceding low points, offer a bullish indication. Conversely, failure of the rallies to penetrate previous high points, with ensuing declines carrying below former low points, is bearish. Inferences so drawn are useful in appraising secondary reactions and are of major importance in forecasting the resumption, continuation, or change of the primary trend. For the purpose of this discussion, a rally or a decline is defined as one or more daily movements resulting in a net reversal of direction exceeding three per cent of the price of either average. Such movements have but little authority unless confirmed in direction by both averages, but the confirmation need not occur on the same day.

I believe the daily fluctuations of price can be a very important factor in catching the early tenures of a Secondary Reaction, and since many traders are only interested in catching intermediate trends, it is of much importance that one understands how a Secondary Reaction works.

While I admit that it is not and easy matter to understand moreover play it as a technical price formation, but knowing its basic formations can prove to be a very powerful tool when playing against the Primary Trend. So we get back to the simple rules of Charles Dow in Trend determination and a Setup which is much used by Victor Sperandeo and Jerry of trading-naked Price Setup called The Dragon.

Figure 3 is a classic technical setup basing on the technical tenet of The Dow theory on trends. Price made a lower high and a break of the low indicates possible emergence of a secondary reaction. All these are derived by purely watching the daily fluctuations of price.

http://img141.imageshack.us/img141/1...agon123ra0.jpg

Figure 3

The discretionary trader needs to note that even though he is playing within the bounds of the theory, the Primary trend is still very much intact.

Lines: A “line” is a price movement extending two to three weeks or longer, during which period the price variation of both averages move within a range of approximately five per cent. Such a movement indicates either accumulation or distribution. Simultaneous advances above the limits of the “line” indicate accumulation and predict higher prices; conversely, simultaneous declines below the “line” imply distribution and lower prices are sure to follow. Conclusions drawn from the movement of one average, not confirmed by the other, generally prove to be incorrect.

The Relation of Volume to Price Movements: A market which has been overbought becomes dull on rallies and develops activity on declines; conversely, when a market is oversold, the tendency is to become dull on declines and active on rallies. Bull markets terminate in a period of excessive activity and begin with comparatively light transactions.

This is my primary concern when trading the Dow Theory in relation to FX. The best correlation that we could get to Volume thus is only by tracing momentum, using Channels or momentum indicators.

Double Tops and Double Bottoms: “Double tops” and “double bottoms” are of but little value in forecasting the price movement and have proved to be deceptive more often than not.

I tend to disagree with Hamilton that double tops and bottoms do not give much indication to a trend. These price setups do give a possibility of a few scenarios:

- Result in the formation of a line
- Indicate a possible change in price trends (can be confirmed by the formation lower high)

So now after jesting so much on the theory, what can we derive from all this?

- Price correction which is less than 50% of any known swing does not constitute as any form of Reaction, they are therefore counted as mere fluctuation in prices
- If Price correction aggregates and reacted by more than 80% of a known swing, there are dire indications that a possible shift in strength is in motion; it is though still quantified as a Reaction.

http://img152.imageshack.us/img152/6...tuationaz7.jpg

Will we see a new corrective A in motion? And if it does what are its characteristics? Note this time if this A corrective wave sets in motion it will depict a high which is lower than the previous Primary Swing. This is a good signal that we are likely going to meet a new wave of correction or will price be submitted into a “Line”. So far I’ve been seeing such a strong characteristic in not only the indexes. Are we at the verge of a new trend change?

Great thread Jest.

One of my trading strategies is based on DJ Theory. I think your observations are correct and, especially with GBP/USD, we are at a critical stage. There needs to be a strong surge up to continue the present trend. Prices, at the moment, are not far off the long term support line, which is generally a good place to buy in. Without a strong surge north we are in danger of going sideways into a reversal or even a protracted J-Lo (round top/round bottom). Looking at fundamentals though, the US economy not so hot and I'm even getting swaps on my GBP/USD buys these days. We could see a move to higher prices unless the UK economy hits hard times. At the moment, though, I'm sticking with the trend until there are signs that it has finished.

keep up the posts - great reading

For those who are sorta lost

- Primary Trend = Long Term Trend
- Secondary Reaction/Primary Swing = Intermediate Trend
According to Dow, this is the hardest and most deceptive but if we understand price and time relations it would be a great catch.
- Reaction/Price Swing/Fluctuations = Short Term Trend

regards
jest

This is not any inducment. Im using this to test if the theory can hold its own on lower timeframes. The rules are simple. Detect primary trend. Identify intermediate trends and forecast future positions. I am using EurUsd as an example but i must say, i am doing this test at the wrong time...the markets are indicating a staged dollar rally but as the fundamentals of the theory holds....right now we are still very much in the bull phase and any corrections which has completed its corrective courses of waves should be taken in as a good bullish reversal signal.

http://img457.imageshack.us/img457/2985/chartef4.th.jpg

continued from post "Putting it all together"

To further fuel my suggestion that USD is likely to stage a rally and create a new secondary wave of correction i have attached the chart readings of USDX, indicating a divergence with the current COT data. While this does not indicate any possible change in trend, we could likely see that the dollar should be bottoming out in the mear/mid term.

we refer to the rules that i have made in my attempt to approach the theory in a systematic manner,

1. Every Secondary Reaction has the potential to turn into a Primary Bear.
2. Every Secondary Reaction and Primary Swing usually moves in 3 phases, A-B-C.
3. Most Secondary Reaction usually retraces to approximately 30-50% of the Primary Swing at extreme cases price will retrace al full 100% indicating dire conditions/manipulations but no real change in market fundamentals yet.

Why do I indicate usually in bold? This is because i want to reflect that Charles dow did state that the theory is not infallible and market does carry a certain level of uncertainty which could only be fully reflected in price and fundamental correlation.

The price has made a final reversal forced into consolidation my huge momentum. The formations are not too encouraging, Wave C might not fulfill its criteria as a new swing yet as the previous correction is likely too shallow.

I personally believe the best indicator used to understand momentum is by using channels.

First i would like to add there are 2 kinds of momentum in general.
- Price momentum
- Swing momentum



my observation about swing momentum, has given a conclusion that:

"Periods where a strong correction is about to will occur can be located by identifying periods of short discernable swings that will force prices into a 'line' or a new high that more often than not fails. These periods will likely last from 1-3 months or 3-5 waves of small swings before we see a strong move into 'Value' areas."

http://img139.imageshack.us/img139/159/momentum2js3.jpg

When prices breaks a channel in the direction of its primary trend, it indicates the presence of strong momentum and wny weakness should be taken as an oppurtunity to collect.

On Drawing Channels




I usually derive my channels by locating two pivots that could encapsulate the whole trend. The largest of the last few swing should never be used as a swing pivot, unless it is just a coincidence that price happens to rest on the bottom of the channel.

Channels should not be used as trendlines, its basic use is none other than to:

1. identifying relative strength.
2. find value ares during a correction from the upper boundary to the lower boundary

http://img525.imageshack.us/img525/9...mentum3lg4.jpg

Lets observe GBPUSD's daily fluctuation and make some cooments about it.

1. We have already missed collecting it at 'value'
2. We observed that as price challenges a the high, the swing momentum is not strong enough to drive prices to move back into the upper channel boundaries, already suggests a possible presence of weakness.
3. Consolidating small swings indicating that price has been driven into a line further suggesting that a possible compromised trend is on the cards.

Keep it going bro, looks like you've been reading up these few days, quite chim but i'll try to follow.

Just wanted to say thanks for the great job of placing these awesome examples in the forum, it has been delightful reading them all.

I think this weekend I will spend a few hours more reading over this again.



Ken

Loving it! Great reading and will certainly wait for more! I imagine for as long as I am in the forex arena I will never stop learning!

Leon

Thank you guys.

I'll continue where i left off. From my previous observations on EURUSD, we have seen that The current demand for USD has not been encouraging and this in turn has made EUR such an attractive currency.

It baffles me how easily the EUR is trading at its current level. While I was expecting some kind of resistance, it surely did not seem to be existant.

The interest rates statement released on the 1 Nov 07 could have provided the impetus for a stronger Euro movement. We could clearly see that Eur has started to pick up some momentum a few days after the statement release.

I'll be closely monitoring price here on, its a scary level to trade at but the signal to go long is pretty clear. While i still feel that USD should at least have some form of retracement if it has any dignity left...but the price movements are not suggesting any sort of corrective expectations. Wave C is here to stay...

Hello,

Been a long time since i posted here. Since my last post on momentum, a month ago, i have stressed the weakening momentum in prices exampled by the GBPUSD. We have seen a significant retracement in all USD related pairs.

Back to our study on Eurusd.
We have seen that the Euro has corrected significanty, the pips retraced are a little more than the one during the subprime scare in august. I believe we have seen the Euro at an attractive level. A value hunter will find that Euro is now going at an offer rate.