The Dow Theory: Basics and Recaps for Crypto
Well, what do you think about technical analysis? Our opinion is it can be quite useful when you want to make a more informed trading decision. By the way, that’s why Superorder partnered with TradingView — to let you trade from charts without wasting time on switching tabs.
Anyways, charts and other aspects of TA are helpful in many cases. Surely, you shouldn’t forget about fundamental analysis, as well as your intuition. But tech things shape the basement. Hence, our today guide is about a classic approach to this analysis type. It’s called the Dow theory.
Disclaimer: the following information isn’t an investment or trading advice. It discloses a theory which principles aren’t stable or 100% proven. Always do your research before making any decisions.
A Short History
Okay, let’s begin with the beginning. The Dow theory is one of the most basic visions on technical analysis in stock trading. However, it can be used in other sectors, including our beloved crypto trading. The idea is based on the writings of Charles Dow, the first Wall Street Journal editor. You may know him thanks to the Dow Jones Transportation Index and the Dow Jones Industrial Average — one of the most famous stock indexes.
What’s interesting, Dow didn’t consider his concepts as a theory or so. After his death, another editor called William Hamilton gathered his colleagues, reviewed the writings, and presented them as a trading framework. Further, we will take a look at the main concept, six major tenets, and their effect on trading markets. Surely, we won’t forget about cryptocurrency so you will find something useful.
Key Principles of the Theory
The theory itself relies on several points, including general market responsiveness, market trends, chart studies, correlation of indexes, volume, and a bit of sector rotating theories. No more words. Let’s look at primary principles one by one.
1. The Market Has Three Types of Trends
Some traders believe that Charles Dow established the very idea of market trends. Today, we interact with them regularly but a hundred years ago they weren’t as popular. Dow said that each market has three critical types of movements:
- Main trend. Lasts from one to several years, defines the most global way.
- Secondary trend. Lasts from a week to a few months, reflects medium moves.
- Minor trend. Lasts from a few hours to a month, shows the tiniest changes.
Of course, all three movements can exist simultaneously. Traders can see a bearish minor trend as a part of a larger bull move which is also a part of a global drop. Trends reflect the market life so we suggest studying them carefully if you want to succeed.
A crypto parallel: while trends in crypto trading may feature smaller timeframes, their types are the same. For instance, a trader can benefit from spotting a bearish secondary trend during a huge rise. Thus, he/she can buy the dips to sell coins after the price moves up again.
2. Each Trend Has Three Phases
Moving deeper, Dow insisted that the main long trends feature three essential lifecycle phases. These steps are also familiar to us today. But don’t forget that the theory was introduced in the early 1900s…
So, the phases proposed by Dow are as follows:
- Accumulation. At this point, an asset valuation is low and the sentiment is negative so smart investors start buying. They remember the rule: be greedy when others are fearful and vice versa. Rates grow slowly now.
- Public participation. Here, the audience realizes the opportunity and begins purchasing assets quickly. Traders follow the way of early adopters but they can’t hope for equal earnings. Prices start skyrocketing.
- Distribution. Regular traders try to earn more by speculating. However, first investors see that the trend is losing its power so they start selling an asset. Eventually, the price stops growing and reverses.
Note that this sequence is valid for bullish trends while bearish ones feature the reversal order. They start with distribution from acknowledged traders, are followed by mass interest, and end up with the final accumulation before an expected reversal.
A crypto parallel: well, we all know it. Fall 2017 started with the slow growth of BTC prices. Whales and professionals who spotted its potential purchased around $3,500–$5,000. Lucky followers entered at $10,000–$15,000. Hamsters jumped in near $19,000. And then early birds distributed their assets, took profits, and started the crypto winter.
3. The High Volume Confirms Trends
This point of view is way more popular today than it was in the days of Dow. Nevertheless, he postulated that the high volume is an essential secondary mark of a true market trend. In other words, low-volume price swings should be studied more carefully as they may be false. The higher the volume the more chances that a related trend is valid. It works for all types of trends mentioned above.
A crypto parallel: let’s look at two examples. The first one is a bullish trend in which ETH skyrockets from $400 to $800 and almost reaches the daily volume of $5 billion. The second one reflects the same jump but with a volume of $3 billion. Guess which trend continued and peaked at $1,400. That’s easy.
4. Only Primary Reversals End Existing Trends
Another idea of Dow was focused on the market noise. He thought that the main trends have huge potential so they can’t end quickly. That’s why he postulated that prices may go in directions opposite to the existing main trends but they return to initial directions soon. Only the starts of new main trends end previous ones, according to the theory.
A crypto parallel: probably, this principle is the most difficult one. Even today, we can’t say for sure where is the main reversal and where is a secondary or minor movement in a bigger — unchanged — trend. Try to answer by yourself: was the crypto winter a new main trend because it lasted for two years? Or it was just a secondary bearish pattern?
5. Market Indexes Confirm Each Other
Another significant indicator of a strong main trend is cross-index verifications, Dow said. In a nutshell, it means that a trend seen on one market should be confirmed by a similar trend in another market. A great example is two averages moving in the same direction and, ideally, with the same strength.
Back in the day, Transportation and Industrial Dow indexes represented this vision, mostly. Charles Dow analyzed the boom of the American industry and compared it to the performance of local railways — main delivery ways. Thus, when one market rose, another one faced growth, too, as they were heavily connected.
A crypto parallel: today, the idea of cross-index confirmation seems a bit outdated. The original vision doesn’t work in crypto because digital economies don’t require physical delivery. Still, seasoned analytics can find correlations between other indexes, e.g. BTC growth and fiat weakening (yep, it’s a reversed confirmation).
6. The Market Reflects Everything
The last hypothesis is pretty arguable but let’s review it, too. Dow stated that markets discount all events or, alternatively, that prices reflect all available data. Even before this data is revealed officially. For instance, if the community expects a business to report a huge profit boost, prices will grow before the report publication date. Even more, rates slow down after the publication and may even reverse if the reported growth would be lower than expected.
A crypto parallel: today, we often see how news and mass sentiments affect prices. Cryptocurrencies can’t exist without developers and users. These communities may expect rises and declines so they affect the prices. Still, it’s a classic “chicken or the egg” dilemma — we can’t say if the markets know everything or they just respond to the sentiment.
Some Conclusions
While the Dow theory may look a bit outdated to you, it’s one of the cornerstones of trading. Regardless of the market, you can use the mentioned principles to understand how prices move, how charts form, and how people make their decisions. By combining this framework with other TA ideas and FA visions, you will be able to master some levels of crypto trading. Good luck!
