What is the Dow Theory? Defining Trends and How to Switch Eyes

Using Dow Theory to set one’s line of sight and switching one’s line of sight in response to changing exchange rate conditions is an important skill that forms the basis of technical analysis (chart analysis) in FX.

Dow Theory is a theory for analyzing market price movements and making trading decisions.

In the previous article, you learned that the basis for judging chart price movements is to divide them into two patterns: the “trend condition” and the “range condition.

In this article, we will discuss the “trend” of the two, and explain how to clearly determine the trend state and switch your eyes to it, using the Dow Theory, a very useful law.

If you have not read the previous article, please click on the link below.

Explanation　How to classify FX market conditions into two categories: trend and range?

Need to have “clear criteria” for trends

I think you already have the rudimentary knowledge of how to distinguish between trends and ranges, which is the first step in technical analysis.

However, to be able to judge the trend and range on an actual moving currency chart, it is not enough to just have the knowledge.

At the moment, you can judge trends and ranges reasonably well with a “clear view of the past and future” of a stopped chart.

However, in the real world, where exchange rates move in real time, this is still not enough.

In order to be able to make clear “your own technical analysis” on the spot without knowing the future of price movements, you need to have “clear criteria” for trends.

There are two types of trends: up and down.

As a recap from the previous issue, a “trend state” is a state in which there is a sense of direction in the price movement on a chart, which can be recognized at a glance as “Oh, it’s moving up (or down).

The state in which “the rate is moving upward” is called an “uptrend,” and is also referred to as a “buy-side” (upward trend).

The opposite condition, “the rate is moving downward,” is called a “downtrend,” which is also called a “downside trend” (also called a “sell” trend).

There are thus two types of trend conditions: “uptrend” and “downtrend.

Basically, there are only these two types of trends, but there are a series of “complicated situations” that are difficult to judge in actual charts.

Up? Downward? Or? Cases in which it is difficult to determine the trend

You may be thinking, “So all I have to do is look to see if the price movement is directional and decide if it’s up or down, right?” You may think it is easy.

However, in actual charting, there are many situations in which it is difficult to make a decision.

For example, what would you do in such a situation?

“Poof, I think the direction is up, but the rate is going down in the middle and at the end. ……”

So how about this?

You say, “Well, it went down a lot, so I think the price action there is in a downtrend, but then it keeps going up, so is it in an uptrend?”

What do you think? It is hard to judge, isn’t it?

In the actual field of technical analysis, there are far more cases of such confusion in judging trends.

“Dow Theory”, a strong ally in determining trends, is now available.

There is one thing that can be a strong ally in the problem of judging trends in these market conditions.

That is the Dow Theory.

By using Dow Theory, it is possible to have clear criteria for judging trends.

Even in situations such as the one we just saw, where it is difficult to determine the trend, you will be able to determine whether the trend is currently uptrending, downtrending, or has ended.

Then you will be able to decide whether it is more advantageous to buy or sell, and in which direction to trade.

This “judgment of which direction is more advantageous” is called “setting one’s eyes on the market.

This “line of sight” needs to be switched in response to changes in market conditions, and this is called “switching lines of sight.

And this is an important matter in establishing a trading strategy.

From here, we will explain how to set and switch one’s line of sight through understanding trend judgments using Dow Theory.

Six Laws of Dow Theory

Now, Dow Theory consists of six laws, each of which has its own meaning.

However, in actual forex trading, you only need to understand a few of them.

Looking at this alone, it may seem like “I don’t understand what’s going on,” but rest assured that I will explain it in detail in the following paragraphs.

The important rules in FX trading are the first, second, third, and sixth rules, and I will explain them in order.

Dow Theory 1. “The average incorporates all events.”

You must be wondering, “What do we mean by ‘average’?

It refers to the rate (price movement/price) itself that appears on the chart.

But you probably ask, What are you talking about? I think so.

In the case of FX, rates move due to all kinds of events in the world, such as the announcement of economic indicators, major events, statements by key figures, and various news (this is called “fundamentals“).

Then, it is not necessary to trade based on all such events.

Some events cause us to say, “Buy! Sell! It is impossible for you to know that, and there is no need for you to try to know that.

But it is impossible for you to know that in the first place, and there is no need for you to try to know it, because whatever their intentions are, the buying and selling behavior born from those intentions will be clearly shown on the chart as price movements.

In other words, the true intentions of the market participants are displayed on the charts in the form of price movements.

Whenever large traders actually buy or sell, their actions are recorded on the charts as changes in the exchange rate.

You can take advantage of the “truth of people’s intentions” as they appear on the charts.

This is illustrated by the Dow Theory, which states that “averages (prices and price movements) incorporate all events.

In other words, the Dow Theory teaches, “The price movements/rates themselves represent the true picture of all market participants. Therefore, the chart is everything.

Dow Theory 2. “There are three types of trends.”

What?” Aren’t there two kinds of trends: up and down?” If you thought so, you are astute.

The “three types of trends” in the Dow Theory are different from that.

If “uptrend” and “downtrend” refer to “the direction of the trend,” then “three types of trend” refers to “the scale and size of the trend.

In other words, it means this…

Suppose the daily chart is in an uptrend.

If we take that chart and convert it to a 15-minute chart, we can see that the part of the chart that was in an uptrend on the daily chart is now in an uptrend, a downtrend, and a range on the 15-minute chart, all mixed together.

In other words, each time leg has its own individual trend condition, with a medium-sized wave within a larger trend wave, and a smaller wave within a larger trend wave.

The Dow Theory calls this the “three trends.

Suppose the chart you are looking at is an hourly chart.

It is very important to look at the chart and say, “The hourly chart is in a range, but the daily chart is in an uptrend,” or “The hourly chart is in an uptrend, but the 5-minute chart is in a downtrend,” in order to trade with an advantage.

Dow Theory 3. “Major trends consist of three stages.”

There it is again: “3”.

What do the three phases mean?

It refers to the three characteristic phases of a trend as it begins and ends.

The “leading phase” is the initial state of a trend, created by traders who believe that a trend is about to begin.

The follow-up period is when traders who have decided that “the trend has started! and traders are joining the market one after another.

At this point, the chart becomes visible to all observers as a trend.

The “profit-taking period” is a time when traders say to themselves, “This is a trend, no matter how I look at it!　I don’t want to miss out! and “I don’t want to miss the trend!

The “profit-taking period” is also the time when traders who had positions in the preceding and following periods take profits.

Thereafter, the combination of sell orders to take profits and “stop-loss” orders by traders who entered the market late and failed to ride the trend causes the rate to fall sharply and the trend to end once and for all.

Rather than trying to understand the details here, it is sufficient to understand that a trend starts in a period of uncertainty, goes through a period when everyone can see it is a trend, and finally reaches a climax and then ends.

Dow Theory 6. “The trend will continue until a clear signal occurs.”

The fourth and fifth are not directly related to the content of this article, so I will skip the explanation.

Now, the sixth is the most important one in Dow Theory, and even if you forget the other five, this is a very important point that you should not forget.

Trends do not last forever and ever.

It will end at some point, the price movement will stall, it will range, or the rate will reverse.

The problem with trading is determining, “Is it in a trend now?” and if it is trending, the problem is “Is it trending?

And if it is trending, the question is, “When do I know the trend is over?” The problem is when the trend is over.

The sixth law of the Dow Theory, “A trend continues until a clear signal is given,” helps us make these difficult decisions.

By understanding the “clear signal,” you will be able to determine what the trend is currently doing.

Let’s take a step-by-step approach to understanding “clear signals.

What is the definition of trend in Dow Theory?

First, let us clearly define the trend condition.

The definition of a trend is also clearly defined in the Dow Theory, and we will tell you that at the beginning.

The high price is rounding up and the low price is rounding up with it. An uptrend is defined as a price movement that meets these conditions (a downtrend is the opposite).

In other words, as long as the high and low prices continue to rise, the uptrend is considered to be continuing.

In other words, the rounding up of highs and lows is judged at the “timing of renewed highs” and the rounding down of lows is judged at the “timing of renewed lows.

This is a clear and basic method of judging “rounding up” and “devaluation”.

It may seem difficult to understand in writing, but if you read it again while looking at the previous diagram of the rounding up, you should be able to understand it easily.

Thus, the Dow Theory determines the state of a trend by paying attention to “what the highs and lows are”.

Once again, the following chart shows that this definition of the Dow Theory is true.

What is a “clear signal” of a trend?

It has become clear that what is important in a trend is “what are the highs and lows (transition of highs and lows).

This means that by looking at these highs and lows, we can determine whether the trend is in a “trend state,” or whether the trend has temporarily ended with a yellow light, or even whether a trend in the opposite direction has begun.

The first thing to pay attention to is “the low price one before the high price” and “the high price one before the low price.

A break below the “low before the high” or a break above the “high before the low” is a break from the definition of an upward or downward trend.

Therefore, it indicates that the market is no longer in a trend.

Therefore, “the low before the high” and “the high before the low” are very important points in determining the trend.

These important points have names and are called “push low” and “return high” respectively.

When the price breaks out of the “push low” and “return high,” it is out of the definition of a trend, which means that the previous uptrend or downtrend is over, and there is a possibility of a trend reversal.

Let’s take a look at how the trend is changing according to the Dow Theory’s definition of a trend.

The above chart shows that the uptrend turned to a downtrend when the rate fell below the low of the uptrend, and then fell below the low of the uptrend to a clear high (below the blue dotted line).

In the case of an uptrend, the uptrend ends when the price breaks below the push-low, which is a “clear signal” of the end of the trend according to the Dow Theory.

It is important to note, however, that even if the price breaks below the push-low, the uptrend has not yet turned into a downtrend (although the uptrend is over) unless a new low is made and the high is clearly cut.

In the figure above, the push-low has been broken down and the uptrend has temporarily ended.

However, at this point, the low (created by the break below the push low) has not been broken below, and the high has not yet been clearly devalued, so it cannot be determined that a “new downtrend has begun.

In this situation, we are no longer in an uptrend, since we have fallen outside the definition of an uptrend, but we are not yet in a downtrend.

Therefore, we can conclude that it is still possible to be in both an uptrend and a downtrend (leaving the possibility of an uptrend resuming).

And in the figure above, the uptrend then resumed and the rate went up.

If you know this much, you can set your sights on it.

If you have followed the content up to this point, you are one step closer to being able to set your own line of sight.

Once you have a clear line of sight, it will be a great asset in developing your trading strategy.

What does it mean to establish a line of sight?

Let me explain again what “establishing a line of sight” means.

The “line of sight” indicates whether you are in favor of buying or selling on the current chart.

So, “establish a line of sight” means, “Is the trend still likely to continue?” Is the trend about to turn? and decide whether to buy or sell.

If you look at the chart and decide, for whatever reason, that “buying is favorable! then you have decided to take the “up side (buy side).

And the Dow Theory is a valid reason to do so.

How to use the Dow Theory to establish a line of sight

The way to establish a line of sight using the Dow Theory is simple.

If the high and low are rising and the market is in an uptrend, the “buy” line of sight is to stay in the uptrend until the price breaks below the low.

When the price reverses and breaks below the push-low, stop “eyeing the upside.

The quickest way to make a decision is to switch to a “downside” line of sight as soon as possible at this point. However, since a “cutback of the high” has not yet occurred, this does not mean that the market is in a downtrend. This means that we have set our “eye line” to the downside.

Why would a break below the push low make it a lower line of sight?

The reasons for taking the line of sight lower at this time are as follows.

First, the break below the push-low is expected to result in the following collective psychology among market participants.

Thus, it can be thought of as a situation where both buyers and sellers tend to agree on a “sell,” and although the downtrend has not yet started, the intention is to set one’s sights lower and look for a trading opportunity.

If a downward trend starts after a lower high price actually occurs, then we can judge that it is a clear “downside” line of sight consistent with the direction of the trend.

Of course, this is not the absolute way to judge, and there will be traders of all sizes with diverse criteria.

In addition, it is also necessary to adjust the judgment depending on the situation on the upper time chart.

This is just one of the basic ways of judgment, but it is certainly one of the reasonable judgments in accordance with the trend of price movements.

Let’s practice using the Dow Theory to set our sights.

Now, let’s practice establishing the line of sight for buying and selling together using the method of establishing the line of sight.

Using the charts discussed at the beginning of this article, let’s take turns to determine whether we are looking up (buy) or down (sell).

Let’s start from the left side.

Suppose that at the time the high “1” was set, the high and low continued to rise, and the uptrend was continuing.

When the high price “1” became the highest price, the low price “A” was one level before the high price, and this low price “A” is the “push low” at this point.

Until the price breaks below the push low “A,” the uptrend can be judged to be continuing, and it can be determined that “the line of sight is the upper line of sight.

A situation where you wonder if you are looking up or down.

From the high “1”, the price is zigzagging downwards.

Here, you may ask, “Isn’t this a downtrend, since the high and low are cutting down?” You may think, “Isn’t it a downtrend?

Please remember here.

The Dow Theory defines a trend as “the high and low prices moving up (or down).

However, the trend continues until a clear signal is given.

The signal is generated when the price breaks below the low before the high, i.e., the “push-low.

Therefore, as long as the price does not break below the push low “A,” the uptrend is considered to be in an uptrend, so even in this zigzagging downward trend, the “line of sight” is upward.

If you’ve made it this far, you’re good to go.

Then, after the low “B” was made, the price rose quickly and reached a high of “2”.

At that point, the previous low “B” becomes a new push low.

Then, from the high “2,” the rate moved in a zig-zag manner again, cutting the high.

This is the same price movement as the previous scene, so the line of sight should be set immediately.

Since the price is above the low “B,” we can judge that this is also a “line of sight” to the upside.

After all, the chart shows that the price has been looking up all along.

At first glance, it looks as if the price is zigzagging up and down, but the trend continues to rise, and it is advantageous to take a buy trade opportunity.

Cases that require a switch in line of sight

Let’s take another chart and practice establishing the line of sight. Here we will look at switching the line of sight.

Suppose the downtrend continued from the left side.

At the low “1”, the return high is “A”, so the eye is on the “downside” until the rate breaks above this high.

The rate then broke above the return high “A” and reached a high “B.” At this point, the downtrend was no longer in a downtrend.

At this point, the downward trend is considered to have ended once and the eye line switches from a lower eye line to an upper eye line.

As I mentioned earlier, it is important to note that at this point we are in a “situation where we do not know what will happen to the price movement,” meaning that “the uptrend or range may become an uptrend or range, or the downtrend may continue (resume).

The downtrend has ended, but there is still a possibility that the downtrend will resume.

In planning a trading strategy, it is important to think, “Let’s set our sights on the upside at an early stage and aim to buy, but we can’t yet see a trend reversal. However, since the trend has not yet turned, we should not force the market to hold.

Now, when the high “B” was reached, I switched my eyes to the “up” line. Then, we judge the previous low “2” to be a push low and draw a horizontal line (line).

If the price breaks below the horizontal line (line) of the push-low, I switch my line of sight down again.

The price will then break below the push low “2” as shown in the figure, and the line of sight will now switch back to the downside.

The rate hit low “3”, then made another high “C”, and when it broke below low “3”, the high and low were also clearly cut off, and the downtrend resumed.

Notes on setting eyes on or switching between

The first thing to understand is the reality that there is no mathematical “formula” or “right answer” for how to set your sights or switch your eyes.

We traders tend to get caught up in the assumption that “this is the right thing to do, this is the way it should be done!”

In the world of the market, where the future is unknown, it is natural to want to find the right answer.

What is important, however, is that “How do other traders in the market view this chart?”.

In other words, imagine the collective psychology of market participants, especially large traders.

If you see an uptrend at a glance, it is likely that everyone else does too.

Conversely, if you are unsure of your line of sight on a chart, it is likely that everyone else is too.

Therefore, it is sufficient to reserve judgment on your line of sight in difficult situations and then calmly determine your line of sight after a clear rise or fall in highs and lows appears.

Once a rounding up or down is made through a prominent high or low that everyone can see as important, you can confidently make a decision there.

And the more your trading experience, the more accurate your decision-making skills will become (including wait-and-see and pending decisions).

The utility of using Dow Theory to define the line of sight

By using the Dow Theory to set your trading sights on the highs and lows that will be the focus of your attention, you will see a significant effect on your trading.

It means that you will no longer be swayed by short-term price movements.

For example, when you are in a situation where you are not sure whether or not the price will break below the low, the following tragedy will be prevented.

When you have a firm axis of trade that you can say with certainty, “This way! By having a firm axis for trading, you will be psychologically unmoved by price movements in the opposite direction.

Also, when the price moves in the opposite direction, you will be able to think, “There should be a high probability that the price will move this way, but the fact that it didn’t makes me wonder if there was an unexpected price move. This is a good way to think about it.

This will allow you to trade calmly in a direction that many traders feel is unexpected (a surprise price move).

The Dow Theory’s definition of trend and how to set your sights on it and switch between the two – Summary

In this issue, I have explained in detail the basics of the technical analysis method, which uses the Dow Theory to determine the state of a trend, set a line of sight for buying and selling, and switch lines of sight according to the situation.

Through learning about the Dow Theory, I hope you have gained a concrete understanding of the definition of a trend, the point at which a trend temporarily ends, and how to set and change one’s line of sight.

Many novice forex traders in the world are completely unaware of Dow Theory and what they are looking at, and say, “Buy! Sell!” and repeatedly make emotional trades without any knowledge of the Dow Theory or the content of the line of sight.

In Forex trading, it is very important to understand the “trend,” “how to set and switch your line of sight,” and “low push prices and high return prices,” which I have explained in this article.

I can say this clearly from my experience.

The contents I will be sharing with you in the future will be based on what I have just explained, so if possible, please read it over and over again to deepen your understanding.

I would like you to analyze the charts with your own eyes, find the push lows and return highs, and observe how the trend starts and ends.

What is “Dow Theory”? I told you how to define the trend and switch your eyes.

Preview of next installment

In the next issue, we will explain “horizontal lines” (lines), which are essential for technical analysis, and how to draw them.

Please click on the link below.

How to draw horizontal lines on a forex chart and what they mean?

One of the most important elements in technical analysis is the horizontal line. Mastering how ...

fx-mono.com

2023.06.16

Reference Links

Reference　Dow Theory Explained: What It Is and How It Works

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