The basic principles of Charles Dow's theory
All modern trend analysis tools are based on the theory of Charles Dow - founder of Dow Jones & Co. In addition to being considered by traders around the world as the "father" of technical analysis, Dow also developed an important index, which is still relevant and working today.
He was the first to calculate the average price of eleven stocks, nine of which were railroad stocks. With time, this value evolved, eventually becoming the index that characterizes the stock market - the Dow Jones index. As for the principles of technical analysis, the theory of those days, although it seems simple even for beginners, is effective even nowadays.
Postulates of technical analysis by Charles Dow
1. The price takes into account everything.
In Dow's understanding, it means the price of a set of instruments.
2. The market has three trends.
According to Dow, these are three categories: primary (a trend of at least one year), secondary (corrective movements on a trend lasting from three weeks to several months), and minor (a secondary trend correction lasting up to three weeks).
In the modern sense, these categories are determined by the behavior of market participants:
- traders - those participants who open positions for several days; - speculators - those who buy currencies for periods ranging from three weeks to several months. This provides an opportunity to maintain a position for a longer period of time; - investors - those trading participants who open currency positions for many months and years, in order to optimise the formation of their investment portfolio.
3. the main trend has three phases:
a) the accumulation phase - a phase in which more experienced and informed investors, assuming that all bad news about a financial instrument is over and priced by the market, buy it;
b) development phase - the phase when a new trend has opened up and market participants have started to open positions on it;
c) the final phase - a phase in a state of "euphoria", an increase in speculative buying, accompanied by great public optimism, as well as by the media in relation to the financial instrument. Some who bought the instrument immediately begin to close their positions, expecting a market collapse. Most other participants, who do not think so, do not rush to sell.
The third phase can be considered the beginning of the first phase for the start of the move down.
The trends can be found on the charts at different time intervals. On hourly charts, fifteen - or five minute charts, which are most preferred by Forex beginners, the trend is always made up of smaller trends.
The daily trend is made up of smaller time periods which, like a matryoshka doll, include even smaller formations, and so on to the tick, the lowest price chart. It is worth remembering that the main, decisive trends are daily, weekly, and monthly.
4. The prices of the different sets of financial instruments should confirm each other.
A trend will be considered formed when it is confirmed by certain currency pairs. For Forex it means the price movement of the whole profile in one direction. For example - a simultaneous rise in the US dollar of the single European currency, the British pound sterling, the New Zealand dollar, the Australian dollar, etc.
5. Changes in the volume of transactions
Transaction volumes should be increasing when the main trend is in motion, and decreasing when the trend is going against it. For Forex this principle is little applicable, because there is no true information about volumes, while Forex beginners should know that the corresponding indicator on the terminal charts will at best show ratio of traders' instrument purchases - sales within this dealing, at worst it will be just a set of some marks.
6. A trend exists until there are clear signals to the contrary.
Trading in trend markets should always be in the direction of the existing trend. And it is always more likely that the trend will continue than that it will end.
This principle is especially applicable to trends in large formations - monthly, weekly, daily. Here, Forex beginners should not try to break such a long trend with a counter-trend order on a five-minute chart. Most likely, this position will soon disappoint them. The pullbacks and corrections in this case are workable, but first we should make sure that such correction has really started, and that there is a trend of a smaller time formation.
Anyway - the trend is our friend, and as a friend, it may hold us in a difficult situation, pulling out an incorrectly opened position, provided that it was opened in the direction of the current trend, even though wrong.