The Dow Theory and How it Relates to Forex Trading and CFDs

The Dow Theory states that the market is in an upward trend if one of its averages advances over a previous high and is accompanied by a similar advance in another average. Although the Dow Theory was designed for the equity markets, the theory can effectively be implemented in the forex markets. Six factors compose the Dow Theory. The Dow Theory relates to the forex market because the ability of traders to identify a primary trend, based on external factors, can affect the traders’ profit.

Additionally, investors should fully understand what is the fundamentals of CFD trading because it is useful in the forex market, as the concept offers traders significant leverage to boost their positions without having to put down the total cost. (Keep in mind leverage also boosts risk).

First, the Dow Theory is based on the Efficient Market Hypothesis (EMH), which states that share prices reflect all information and stocks trade at their fair market value. Second, a trend continues until something happens to reverse it. Third, the three stages of a price trend are the accumulation phase, the “catching on” phase, and the excessive speculation phase. Fourth, there are primary moves, which show the underlying trend, secondary moves, which are corrections in the market, and minor moves, which should be ignored according to the Dow Theory. Finally, the Industrial Average and the Transportation Average had to be moving together to confirm a trend was real.

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The Dow Theory relates to the forex market. In the forex market, currencies trade against each other in pairs. Factors such as geopolitical risk, interest rates, and economic conditions can impact a price trend, and something must happen to stop it. Through analyzing economic conditions and market factors, investors can better identify the major directions of market trends in the forex market.

Some traders choose to trade with the trend in the forex market, while others try to trade against the trend, which can result in huge losses. Investors’ ability to determine a trend can lead to better trading insight. Using the trend identification combined with trendlines and moving averages, the Dow Theory can be used in the forex markets.

What is CFD trading?

It is important for investors to understand what is CFD trading. Contract for differences, or CFD trading, is a derivative product that allows investors to speculate on financial markets such as shares, forex, commodities, cryptocurrencies, and indices without having to take ownership of the underlying asset. Investors can speculate on price movement in a positive or a negative direction. CFDs are leveraged, meaning that investors can gain exposure to a large position without requiring them to put up the full cost. They are short-term speculative products that do not have an expiry date.

Trading forex CFDs

CFD forex trading allows investors to place leveraged bets on the price movement of currency pairs and the movement of one currency compared to another currency’s price. The expectation is that one currency will appreciate or depreciate. It is common for traders to use leverage in the forex market to take on larger positions in a currency. A trader who is betting that the price of a currency pair will increase will open a ‘Buy’ position (or ‘Go long’), while a trader betting that a currency pair will decrease will open a ‘Sell’ position (or ‘Go short’).

In CFD trading, investors can go long and short with up to twenty times leverage, while only having to put down a small percentage to acquire a CFD position. It is recommended that beginner investors limit leverage to a maximum of 10:1. Going long in CFD means buying the base currency and selling the term currency. On the contrary, going short in CFD means selling the base currency and buying the term currency. Forex CFDs are traded over-the-counter (OTC). They do not have an expiry date and can be closed at any time.

The Bottom Line

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The Dow Theory is based on the analysis of maximum and minimum market fluctuations to make predictions on the direction of the market. Six basic tenets underpin the Dow Theory: the market discounts everything, a trend continues until a reversal occurs, there are three trends in the market (primary, secondary, and minor trends), there are three phases to primary trends (accumulation phase, distribution phase, and euphoria), primary trends must confirm each other across market indices, and share prices must reflect all information.

The Dow Theory relates to the forex market because in the forex market primary trends, which indicate if a market is bullish or bearish, are influenced by external factors such as geopolitical risk, interest rates, and economic conditions. These factors can lead to a reversal in the appreciating or depreciating of a currency. Discovering a trend in the accumulation phase (before a bull market) or in the distribution phase (before a bear market) can help investors make more informed trading decisions.

CFDs allow investors to take on leveraged positions while putting down smaller positions. The concept of leverage is common in the forex market because it allows traders to take on larger positions in a currency. However, while leverage magnifies trading power it also magnifies risk, which must be taken into consideration by investors. Going long means buying the base currency and selling the term currency and going short means buying the term currency and selling the base currency.