The Dow theory is one of the most commonly applied forms of technical analysis used while trading any financial instrument or commodity traded in an open market. This approach to trading was developed by Charles H Dow, in a series of articles published in The Wall Street Journal, which incidentally, is cofounded by Charles Dow along with Edward Jones and Charles Bergstresser. However, due to his demise in the year 1902, his complete theory on stock markets never saw the light of the earth.
The Dow theory, as we know presently, has been developed in its long history of more than 110 years, with contributions from many stalwarts, including William Hamilton, Robert Rhea, and Richard Russel. Some aspects of the theory, like the importance it gives to the railroads and transportation sector in general, has lost prominence. However, the Dow theory remains a fundamentally important part while conducting a technical analysis of any asset. And yes, all the concepts discussed can very much be applied while trading in cryptocurrencies, or their derivatives.
This post will delve into detail about the Dow theory and its components. It is assumed that you are already familiar with basic concepts like support, resistance, and trendlines, so if you aren’t, we strongly recommend that you read up on these concepts here.
What is Dow Theory?
The Dow theory is a financial theory which states that a market is in an upward trend if one of its averages advances above a previous important high and is accompanied/followed by a similar movement in the other average. This can be used by investors to comprehend the state of the market and understand the health of the business environment.
Established as early as in the 1900s, Dow theory is the first theory to explain that the market moves in trends. This theory is based on the belief that the stock market, taken as a whole, can prove to be an extremely reliable measure of the overall business environment. Thus, by understanding and analyzing the overall market, an individual could accurately predict the direction of individual assets.
Though a lot has changed since the 1900s, the concepts of Dow Theory remain incredibly relevant even today, a whole century later. Speak of tried and tested.
The Dow theory has six main components, popularly called the six tenets of the Dow theory. We’ll explore each one in brief detail, along with some crypto trading context.
#1 The Market Discounts Everything
Operating on the efficient markets hypothesis, the Dow theory states that the present price of the asset will reflect all the publicly available information. This means that even if individual persons don’t analyze all or any of the publicly available information – like the future potential, or even possible future failures, which are discounted as risk-premium, the value of the crypto asset will incorporate all the available information. Even before the details are officially published.
This is probably the most debatable hypothesis in the Dow theory, as some argue it’s similar to the chicken and egg dilemma. There is no way to know for sure if the prices reflected are reactive or proactive in nature, i.e, there’s no way to know for sure if the market is already aware of the information, or if it simply responds to the news.
#2 There are 3 kinds of market trends
Dow broadly categorized trends to be of three types, based on the duration of these trends:
- Primary Trends: Trends which last one or more years. This is also called the primary trend
- Secondary Trends: Shorter trends within the primary trend, often working in the opposite direction of the primary trend. Usually lasting between three weeks and three months
- Noise / Minor Trend: Trends that last less than three weeks.
Here’s all those trends identified in a BTC-USDT chart from 2017.
Understanding these different trends will help a smart investor to gain the maximum from any trade, by giving indications on when to enter/exit a position.
#3 Primary trends have three phases
A primary trend will consist of the following three phases
- Accumulation: Smart investors notice that asset valuation is low and a negative sentiment surrounding the asset, and start buying. The trend slowly starts growing.
- Public Participation: The general public will soon want to cash in on the trend, but won’t get the same earnings as the firstcomers.
- Distribution: Traders try to earn more through speculation, but firstcomers realize that the trend is losing steam, and thus exit the position. The trend eventually reverses.
#4 Trends continue unless clear signs of reversal are present
The Dow theory says that primary trends will continue to exist, despite some temporary noise in the opposite direction. Unless there is a definitive indicator indicating a reversal, expect no change.
Applying this aspect of the Dow theory to crypto trading – scroll back to the Bitocin – Tether chart from 2017. The primary trend is clear and prominent, despite short swings and a secondary trend.
#5. Indices Confirm with Each other
According to Charles Dow, a trend seen in one market average should be confirmed by a similar trend in another market. This means, if a trend is seen in one market index, but is not the same with any of the other market averages, that indicates that the trend seen in the index is noise.
Again, let’s apply this aspect of Dow theory to crypto trading. If you were to open up the Bitcoin Futures chart on Delta Exchange and say, in any two other exchanges, you’d need to see a clear consistency in patterns across the charts to confirm its validity as a trend, and not as noise.
#6 Volume Must Confirm Trend
The volume of trades must increase if price is moving in the direction of the primary trend, and decrease if it moves against it. A low volume signals that the trend that is being analysed is weak.
This is one of the fundamental concepts used in technical analysis, and many concepts make use of the Dow theory, including the Fibonacci Retracement tool.
It can be extremely fruitful and alluring to begin right away and start trading in crypto derivatives, but make sure you thoroughly understand and are comfortable with the market risks before investing in any crypto asset.
Here’s a helpful guide on investing in Ethereum futures , for you to begin your crypto trading journey!