As one of the earliest forms of technical analysis and models of markets driven by data, Dow theory serves as an introduction to understanding market trends for traders who are just getting started on their trading journey.
The theory is named after the journalist Charles Dow, who founded the Wall Street Journal in 1889 and regularly used the magazine to publish his analysis of stock markets. Dow was also one of the first people to originate the idea of a stock index, with the Dow Jones Industrial Average (DJIA) named after him.
The ideas laid out by Dow were synthesized in several books such as The ABC of Stock Speculation and The Stock Market Barometer. Applying Dow theory can help traders to time entries by analyzing price trends and volume for stock markets, but these techniques are also applicable to other asset classes, such as cryptocurrencies.
The 6 Principles of Dow Theory
Dow theory is made up of 6 key principles, which are listed below, and provide investors with a framework for organizing information to help them to decide when to buy or sell an asset.
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Market trends move in 3 ways
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Trends have 3 phases
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Asset prices reflect news
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Indices must confirm trends
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Volume must confirm trends
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Trend exists until proven otherwise
Let’s look at each principle in more detail and illustrate how traders can use each one to make better decisions.
1. Market Trends Move in 3 Ways
The saying “the trend is your friend” is often given as advice to new traders. But the question arises: how exactly do we define a trend? The concept of market structure is important in determining the current trend. In other words, traders should look at whether the price of an asset is making higher lows and higher highs, in which case we can say that there’s an uptrend.
On the other hand, if the price of an asset is displaying lower highs and lower lows, then there’s a downtrend. After a prolonged period of falling prices, we should look for the first higher low after the market has bottomed. A higher low by itself does not provide enough confirmation of a trend change, so we want to see two consecutive higher highs and higher lows to be sure that bulls have taken control from bears.
Once we can identify the current trends, we can then look at the three types of trends outlined by Dow theory:
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The primary trend typically lasts for several months to several years. Traders should align their portfolio with the primary trend.
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The secondary trend runs counter to the primary trend, typically lasting 10 days to 3 months. If the primary trend is up, then the asset will often lose between one third to two thirds of the value gained during the primary trend.
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Finally, there are short swings, which last anywhere between a few hours to one month. Short swings are often referred to as noise (meaning they are insignificant).
Examples of these three different trend movements are shown below for the ETH-USD market.
2. Trends Have 3 Phases
All trends can be categorized into three phases:
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Accumulation (or distribution)
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Public participation
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Excess (or despair)
The first phase is accumulation where insiders or more sophisticated traders purchase stocks toward the tail end of a downtrend in anticipation of a new uptrend. For downward trends, the first phase is distribution where insiders sell an asset as the upward momentum starts to level off.
The second phase is public participation, which is when a new upward or downward trend accelerates. Trend followers and other technically driven investors are attracted to the market and begin to buy or sell.
The third and final phase is when insiders sell to the public when an upward trend has grown speculative and the price is in excess of the true underlying value. For a downward trend, the final stage is despair.
Some examples of these three phases are shown by the chart below for the price of Bitcoin. After the sharp drop in BTC-USD in March 2020, we can see that a period of accumulation started. Smart money started to buy at these lower prices as the price of BTC had dropped almost 72% since the market’s peak in June 2019.
As the price broke to new highs in July 2020, the public participation phase began and the upward trend eventually accelerated towards the end of that year and into 2021. But as more investors and 'normies’ started to jump in, speculation started to become a major driver with the market entering the final phase of excess in early 2021. The excess phase was followed by a sharp drop until another opportunity for accumulation occurred in mid-2021 and the three phases were repeated over the following 5 months.
3. Asset Prices Reflect News
Financial markets react quickly to events or news, reflecting new information almost immediately.
That’s why traders should avoid reacting to events or news releases after the fact. Once any new information is out there, the price will have already moved and it’s likely to be too late to use that information to enter a position. This principle is consistent with the efficient market hypothesis, an advance in financial economics that arrived many decades later after Dow’s writings.
Reacting to news means you’re one step behind, when you should aim to be one step ahead. As the famous trader Anton Kreil says, if you can predict tomorrow’s news, you’ll be very successful in the trading world.
4. Indices Must Confirm Trends
The fourth principle of Dow theory is that indices confirm trends.
The most important sectors of the economy in the days of Charles Dow were manufacturing and transportation, leading to his formulation of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) indices. Both of these indices tend to move in the same direction, but when they diverge, the market’s current trend could reverse.
But what’s the equivalent for cryptocurrency markets?
There are many indices tracking the overall health and direction of the crypto-asset market. One of the best examples: Coin Metrics Bletchley Indexes (CMBI**)**, a comprehensive suite of single-asset, multi-asset and unique crypto asset benchmarks that are used by leading financial institutions.
Another relevant index is the Bitcoin Dominance, which measures the market cap of BTC compared to the entire cryptocurrency market. As the most important asset in the crypto sector, the behavior of the dominance index and the price of bitcoin can help us to understand how the price of altcoins may perform in the future.
5. Volume Must Confirm Trends
The fifth principle states that relatively high volume is necessary to confirm primary trends. As the famous expression goes, volume precedes prices. Traders can confirm the health of trend by looking at whether volume is rising or falling. If volume is increasing and buyers or sellers are showing up to the market, then it confirms the primary trend.
6. Trends Exist Until Proven Otherwise
A primary trend should be given the benefit of the doubt. Trends exist until definitive signals, such as declining volume, prove otherwise. To maximize your profit potential, you should only exit a position if it’s clear that the trend is reversing.
Criticisms of Dow Theory
As with any trading technique, there are some drawbacks to this approach:
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Dow theory is not technically an investing strategy, but rather a collection of rules that can be somewhat subjective. For example, one trader may consider the current trend to be primary, while others may perceive it as a secondary trend.
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Dow theory can be late in identifying reversals.
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Finally, another criticism of these 6 principles is that they are outdated since they are based on the observations from over 100 years ago.
Despite these drawbacks, the 6 principles underlying Dow theory form the basis of technical analysis, so it’s worth knowing if you want to dive deeper into using price and volume charts to trade cryptocurrencies. Grasping these 6 basic principles outlined in this article, traders can gain a better understanding of the behavior of the crypto market, remove emotions from their processes and make better decisions.