The Six Rules That Changed the Way We Look at Markets
Technical analysis of the forex market, together with fundamental analysis, is one of the main methods for determining price movement dynamics and forecasting its behaviour in the future.
The analysis is based on using the price movement chart, as well as its mathematical interpretation thereafter. The main advantage of technical analysis is its versatility: using the same tools and techniques, you can explore any currency pairs in any historical segment.
Technical analysis is such a vast topic, that it only makes sense to start from the very beginning.
The ancestor of modern technical analysis is a journalist Charles Dow, who you might know as a co-founder of Dow Jones & Company, as well as the creator of the Wall Street Journal. At the beginning of the 20th century, he was able to formulate basic principles and postulates, which later became known as Dow theory and served as the groundwork for technical analysis. Keep in mind, that these principles were formulated over 100 years ago! In total, there are six such fundamental tenets:
1. Price takes everything into account
According to Dow, the price of the asset has already laid all the necessary information about the past, present and even the future.
Emotions, inflation, data on discount rates, all this is already incorporated in prices, in advance except, of course, even theoretically inaccessible data like the exact date of a new earthquake. But even the risk of this extraordinary event is also embedded in market prices.
All this does not mean that market participants are guaranteed to predict future events. In fact, in market prices, all the factors that influence and can influence in the future are simply concluded. As the situation and market risks change, the market itself changes in response to new information.
2. There are three possible trends in the market
Dow believed that the mechanism of action and reaction applies to the market in the same way as they apply to physical objects; namely, each significant movement is followed by a specific counter-movement. He formulated three types of trends:
a. Primary trend: This is a key market movement. To determine it, it is necessary to open a larger timeframe on the chart, say, monthly or weekly. This global trend, ultimately, affects everything, including minor and insignificant trends.
According to the Dow theory, the global trend lasts for 1–3 years, which, however, may change.
b. Secondary trend: The market is moving in the direction of the primary trend. The secondary trend, as a rule, goes against the main trend or as a correction to it.
This is how the main trend can go up, and minor trends — down.
c. Minor trend: Called the “short swing” this a market movement of up to 3 weeks. As a rule, it is a correction to a minor trend.
All of the types of trends may happen simultaneously.
3. There are three main phases to each market trend
Dow theory believes that major market trends consist of only three phases:
a. Accumulation phase: This is the first phase, the beginning of an uptrend. It is at this stage that investors enter the market. Typically, this phase begins at the end of the downtrend. At this point, the majority of negative news has already been taken into account by the market, due to which investors, despite the low prices, are beginning to see the future as an asset.
From a technical point of view, the beginning of a new trend is always accompanied by a period of consolidation. This is when the market goes into a sideways movement and then begins to show an uptrend.
b. Absorption phase: “Advanced” investors enter the market during the accumulation phase. In their opinion, the worst is over. When the trend really unfolds, the stage of public participation begins.
Economic data is improving, the market is saturated with good news. The more such news, the more investors join at this phase.
c. Distribution phase: At this phase, investors who entered the first phase of accumulation exit the market. And the market begins to show completely irrational behaviour.
Many investors, fascinated by the most influential trend, begin to think that he will always be in a hurry to take part in it. At the same time, the main participants leave it or have already left.
4. Averages must confirm each other
In Dow’s time, the two averages were the Industrials and the Rails. The logic behind the theory is simple: the industrials represent the production of goods and the rails represent the shipments or logistics, which was logical at the time.
According to Dow Theory, the general mood of the market should be confirmed by the coinciding directions of both indices. This is true, of course, for the stock market, but also plays a role for the foreign exchange market. At the same time, if the indices diverge, then there is just no clear trend.
If one average went to an ATH, while the second was lagging behind, it is called bearish divergence. The completely opposite situation is called a bearish divergence.
5. The volume must confirm the trend
Unlike currency pairs, where there are no real volumes, full information is available on the stock market. Therefore, to forecast stocks, it is necessary to take into account both the financial indicators of the companies that issued them and the data on volumes.
According to Dow’s theory, if the trend goes up, volumes should increase. If the price goes against the trend, the volumes should decrease.
If the volumes do not coincide with the trend, this is an indication that it ends. Let’s say the market goes up, and the volumes decrease — the bears begin to pull the market in their favour. If buyers leave the market or they become sellers, then the chances of continuing the upward movement of the market are quite small.
6. A trend is assumed to be in effect until it gives a definite signal of reversal
The trend allows you to determine the overall direction of the market — the trend that it follows. The golden rule says “do not work against the trend”, and this is absolutely true.
According to Dow Theory, the trend works until there is convincing evidence of its completion.
It is important not to confuse a minor or insignificant movement with a real reversal. As a rule, trade against the trend is very risky.
That is it for now! Thank you for tuning in, and we hope to see you next week.
All the best, Visioners!
