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.

Watching AUD/USD

The AUD/USD started weakening a bit at the end of last week after it broke up from its consolidation range earlier in the week. As of just a moment ago the buy price was .8622 so it’s back inside the range of .8543 to .8676. Remember that I wrote that breakouts from ranges, in particular, can be premature or false. There’s no way of telling right now what the real story is with this pair. Here’s the 3-hour chart showing weakness—it violated the 62 EMA it had been roughly using as an uptrend line plus the uptrend line I drew on the chart. It also violated the RSI uptrend line.
None of this weakness means the sky is falling. But it does indicate some uncertainly. So, I have to do what most traders need to do if they’re going to be successful. I have to wait until I get some more clues. Meanwhile I canceled the remaining buy order I had in place, was stopped out of the long I had from .8723, and bailed out of the filled buy order at .8678. So I’m flat. I bailed because I don’t like the weakness it’s showing and don’t have enough positive clues to wait it out as I did when I wrote about the GBP/JPY last week (a trade I’m still in by the way; I’ve set my profit stop at 80 pips)
Overall, it’s important to remember that we’re still in an uptrend and have been so since March. That’s six months. It could be just an intermediate uptrend (according to DOW theory) before a downtrend resumes. So this could be the resumption of the downtrend but I don’t have proof of that or even any overwhelming evidence that would let me assume it to be true.
What clues will I look for that will shape my opinion of the pair at this point?
First, I still believe the consolidation range is important. That means if it breaks upward again from that range I will take another long position. I may try a tiny long if it falls to the bottom of that range as well with an extremely tight stop. There’s also an uptrend line from the daily chart coming in at .8475 so that area is significant. But if it definitively closes below the bottom of the range and the uptrend line I would start to think the trend has changed and would be looking to sell on rallies.
For the time being I have to wait and see.