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Published On: Wed, Oct 31st, 2012

Using the Dow’s Method in Forex Trading

The root of the Dow’s method can be found in a series of articles that Charles H. Dow wrote for the Wall Street Journal in the early 1900s. Despite being around for over a century, the general theoretical framework underlying this theory is as valid today as it was then. After Dow’s death, his theory was refined and further developed by his followers.

Essentially the theory examines indicators from the industrial and transportation sectors. If certain indicators for both these sectors confirm a similar trend, then one could expect that the rest of the economy would soon start following the same trend. If one gets conflicting indicators from these two sectors, it gives a signal that a significant direction change was coming for the market.

A change in the current trend is also signalled when any one of the indicators from the industrial or transportation sectors fail to reach new highs or lows during the current trend, or if they instead reach new highs or lows in the opposite direction.

Not only can this theory be applied to the stock market, but if we extract its very core underlying principles, it can also be applied to the Forex markets.

The Dow theory attempts to identify a change in the trend, rather than to predict future prices. So for forex traders to use this strategy, what has to be done is to wait for a trend to become clearly apparent by using, e.g. the Ichimoku Kinko Hyo – and then using Dow’s method to predict when a change in this trend might be imminent.

What the Dow method essentially tries to do is to follow the trend that currently prevails in the market, using clearly identifiable higher highs and higher lows during bull trends and lower lows and lower highs during bear trends.

This implies that the trader should open a long position each time the market breaches the last high, while setting a stop loss order at the last low. On the other hand, if the market breaks through a previous low, this would be a signal to go short and to place a stop loss at the last highest high.

Fig. 10.18(a) is a graphical illustration of how the Dow method would be applied in real life.


Fig. 10.18(a)

Imagine, for example, a bullish market. Within this trend the trader would ‘buy into the trend’ by taking a new position each time the market breaks through the previous high. At this point the trader should then adjust the previous stop loss set up during the previous trade and replace it with a new, higher one.

This requires a time frame long enough for a clear trend to emerge. Trying to use Dow’s method in a very short time frame will most likely lead to misleading signals.

Dow’s method is also only really useful in trending markets. In a range-bound market the trading signals it gives will lag and become unreliable. Another drawback is also that it requires the trader to continuously monitor the market not to miss any new highs or lows.

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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