Initially, principles of the Dow Theory were used only for the American indices created by Charles Dow: Transportation and Industrial. Most of them, however, can be successfully applied to the foreign exchange market.
Indices discount everything. According to Charles Dow any factor which influences demand and supply will be reflected in the index. These factors cannot be foreseen but nevertheless they are taken into account by the market and reflect index behaviour.
There are three movements on the market. Uptrend is characterised by the fact that every following top is higher then the previous one and every next bottom is higher then the previous one. Downtrend is characterised by the fact that every following top is lower than the previous one and every bottom is lower than the preceding one. When the market is in the flat position every next move (up or down) is approximately at the same level as the preceding one:
Dow classified market trends as follows:
primary trend (it is called a broad one and lasts from anything less than one year up to several years);
secondary trend (it lasts from three weeks to three months and is considered as a correcting trend to the primary one. These in-between rebounds are one-two thirds (or even half) of the range prices move during the primary trend);
daily trend (a short-term movement within the secondary trend, which has very little long-term forecasting value).
Another classification was suggested by Thomas DeMark:
short-term trend (if the price has moved less than 5%);
mid-term trend (if more than 5% but less than 15%);
long-term trend (if more than 15%).
DeMark designed a forecasting method to predict the beginning of a trend, both mid-term and long-term. The method is based on the specially designed coefficients.
The primary trend has three phases. During the first phase all unfavourable market information has been discounted by the market and the far-sighted and better informed traders start to buy. The second phase starts when the traders who do technical analysis enter the market. Once all economic data becomes more favourable, the third, final phase begins, which is characterised by high activity on the market supported by the mass media and optimistic economic forecasts in the newspapers and on TV. Despite the positive sentiment, the final phase is the first sign that the prevailing trend is about to end.
Indices must confirm each other in order for the signal to have authority (referred to Industrial and Rail (or Transport) indices). Charles Dow said that any significant uptrend or downtrend signal on the market must be considered together in the Industrial and Rail indices. If we applied this principle now on the basis of modern technical analysis, it would mean that a signal from one technical indicator must be confirmed by a signal from another technical indicator.
Trade volume must confirm the prevailing trend. If prices move in accordance with the prevailing trend, it increases the volume and inversely, when there is a rebound, volume decreases.
The primary trend remains intact until a change in that trend has been given by the theory. The last major signal remains in force until a new signal develops. Many analysts believe that a bull market must always be moving to new highs. However, the market can undergo extended periods of sideways or lackluster trading without the primary trend changing. If the last major signal under the theory is bullish, the primary bull market trend remains in force until a bear market signal is given.
Trend Lines and Trend Channels
Trend is a general direction of the price.
Prices do not only rise or fall but most of the time they actually move in narrow ranges. So, in accordance with the Dow Theory we can therefore divide trends into three types:
"bull" (or "uptrend") - prices rise;
"bear" (or "downtrend") – prices fall;
"flat" (or "sideways") – prices are in a narrow range. As a general rule, market consolidates prior to a rapid price rise or fall.
First of all, it is very important to determine if the market is uptrending or downtrending (this can be done with the help of trend indicators and trend lines or channels) and if the prevailing trend is strong or weak (with the help of oscillators and charts patterns).
Uptrend line in MetaTrader
Uptrend means that every next bottom is above the previous one, and every next high is above the previous one, so in this case, the trend line is drawn between bottom points. Obviously a trend line created by joining only two points will be less effective than a trend line created by three or more points.
Downtrend line in MetaTrader
Downtrend means that every next bottom is under the previous bottom and every next high is under the previous high, so in this case, the trend line is created by using the highest points.
Any trend (bullish or bearish) must be confirmed by trade volume. Put it simply: when prices move in accordance with the prevailing trend, the trade volume increases; when prices move against the prevailing trend (rebound), then trade volume decreases. Once the situation changes and trade volume during rebounds becomes greater than that during the trend price movement, it is a serious signal that the trend may not be so strong (but it is not the signal to open the opposite position, as there is no confirmation of the trend reversal).
Flat trend line in MetaTrader
A Flat Market means that every next bottom or high is at the same level as that of the previous bottom or high. In this case, the trend line is drawn by joining both bottoms and highs.
In order to draw a trend line in MetaTrader 4 press the button on the "Line studies" toolbar:
Line studies toolbar
Point the mouse cursor to the first trend line point, click and hold the left mouse button to draw the line to the second point. Once you have done this, release the button. If you wish to highlight the trend line, just double click on it. Right-click on the highlighted object to enable the context menu:
There are two types of trend lines in MetaTrader 4: vertical and horizontal trend lines.
With the help of a trend line you can identify the moment when the trend will change. Once a trend line has been broken, chances are that the trend has just changed its direction or its strength has started to diminish.
Sometimes the trend line is broken by a bar low or high, and the price continues to move in the direction of the current trend. There are many methods to define if a breakout is true, hereafter are the most popular :
Trend is your friend - do not open positions against the prevailing trend.
The primary trend remains intact until a change in that trend has been given. Trend line breakout is one of the most important signals that the trend may reverse.
Do not try to open positions against the prevailing trend hoping that the trend is weak and that the reversal point is not far away. In most cases price sweeps through your Stop Loss order and only subsequently does the trend reverse.
A Stop Loss order should be placed below an uptrend line (or above a downtrend line).
Tomas Demark made his contribution to the theory of trend lines. According to his theory, trend is rooted in two critical points through which the trend is drawn. He called these points TD-lines (his name, Tomas Demark, abbreviation). These points are defined at the basis of extreme points.
Channel lines are a significant part of trend analysis. Channel lines are like boundaries for price fluctuations. To create a channel line, draw a parallel straight line next to the trend line: one of them joins price chart highs, the other price chart lows:
Channel lines are used:
To point out where to fix profits and losses. If there is an uptrend channel, Take Profit order may be placed under the upper line and Stop Loss order under the lower line. If there is a downtrend channel, Take Profit order should be placed above the lower line and Stop Loss above the upper line.
If the price does not touch the upper line of the uptrend (lower line of the downtrend) this signifies that the prevailing trend is weak.
In order to create a channel line in MetaTrader 4 double click the left mouse button on the trend line, press and hold the Ctrl button and drag the newly created parallel line to its place on the chart. Then release the Ctrl button.