Wednesday, January 13, 2010

Can you trade theory?

Someone sent me a comment that read, apropos of nothing it seemed, “If the Forex condition is at bull market, investors should start to acquire positions. Careful analysis using Dow Theory is needed to evaluate the movement of the trend.”

I happen to like Dow Theory. However, for a technical trader such as me, it’s only one piece of evidence. In addition, you can’t trade theories. You trade the chart in front of you, especially if you’re a short-term trader. It is important, though, to know the trend of the market in the time frame you’re trading as well as above that time frame. Regular readers know I routinely look at monthly, weekly, and daily charts even if I’m trading off the three-hour chart.

Dow Theory is a theory of price movement that’s concerned with trend direction. It doesn’t concern itself with forecasting. Its goal is to determine changes in the primary trend of the market. This is another reason it’s not useful alone for short-term traders who are in and out of the market. The primary trend is one that can go on for years but within the primary trend, it’s possible to take successful counter-trend trades as the market corrects or consolidates.

The theory has six major tenets. These are:

1) The averages discount everything
2) The market has three movements—primary, intermediate, and minor.
3) Volume must increase as the trend develops
4) Closing price is the most important
5) Averages must confirm
6) Trends are assumed to persist until there is clear evidence otherwise

You can see why it’s difficult to apply this wholesale to the Forex market. First, the Forex market doesn’t have averages such as transportation, utilities, etc. We also don’t have volume. Finally, closing price is undefined in a 24-hour market. Many people use 5 P.M. EST but others use midnight.

There are three movements in every market—primary is the longest term and can last for years; intermediate can be three weeks to three months, and minor can be one to three weeks. There are also percentage retracements one can apply to determine this. It is important to assess where a market might be at any given time. It’s also true that trends persist and that the trader needs clear evidence that they’ve changed. This is why I often write that a pair is in an overall uptrend or downtrend. It helps place price action in context.

What I’d say to the reader who wrote that we should acquire positions at the start of the bull market is, “Not just yes, but hell yes!” That’s what everyone wants to do. However, it’s also very difficult, in part because of the need for clear evidence the trend has changed. Topping and bottoming are processes as I’ve written many times. In addition, the market is often not trending at all but in consolidation or congestion mode. Dow Theory doesn’t help at all then.

We have a rich amount of material to draw upon as technical analysts and we should make use of it. Everyone should understand Dow Theory. However, when it comes to trading, trade the price action that’s in front of you on the chart and practice ironclad discipline. As my monthly results show, you can be very successful doing this alone.

© Dianne Fecteau, 2010. No part of this material may be reproduced in any form, or referred to in any other publication, without the express written permission of the author.

My purpose in writing this blog is to show you how one trader, me, makes trading decisions and survives while trading Forex. One of the biggest problems I had when I first started trading was trying to apply the “rules” to actual trades. Another was the psychology—limiting losses and letting profits run. If you study my blog you’ll see how I deal with both those issues. So my writings are not trade recommendations but rather educational in purpose. You have to decide on your own approach to trading. Remember that trading is risky.

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