What is the Dow Theory?

Technical analysis, a trading technique used to speculate on price movement, goes as far back as the 17th century, with several methods arising in different geographical locations. Today, technical analysis is rife with several theories, analytical tools, and charts. Nevertheless, some old principles have been retained and adopted in modern financial markets, often incorporating computer-assisted techniques.

One such principle is known as the Dow theory. It was created by an American journalist who noticed patterns and market cycles or trends by looking at data on financial markets. His findings were eventually published and used as a stock trading strategy.

This article breaks down Dow’s theory and six of its most important rules and explores its application in cryptocurrency markets.

Who Created the Dow Theory?

The Dow Theory was developed by an American journalist, Charles Dow. Dow, Edward Jones, and Charles Bergstresser were cofounders of Dow Jones & Company Inc. They jointly developed the Dow Jones Industrial Average, a stock market index that currently tracks up to 30 companies on stock exchanges across the US. In 1986, Charles Dow roughly outlined the Dow Theory through a series of editorials in a publication he co-founded, the Wall Street Journal.

Dow died a few years later, leaving the belt of his work on the theory incomplete. Nevertheless, other associates and followers of his work took up the mantle and expanded on his editorials. Some prominent contributors include William Hamilton and Alfred Cowles.

What is the Dow Theory?

The Dow Theory is a technical analysis theory used in stock market analysis. Developed by a journalist and co-founder of the Wall Street Journal, the rough version of the theory involved comparing the prices of two averages (indexes) at closing. Charles Dow, the theory developer, proposed that if one of the indexes rose above a threshold, the second index was soon to follow.

He described this occurrence as an upward trend. Dow’s theory focused on analyzing the stock market as a whole to determine the general market trends and make speculations on the direction of individual stocks.

The Six Basic Tenets of Dow Theory

The modern version of the Dow theory comprises a list of rules or guidelines. There are six primary rules known as the paradigms or tenets of the Dow Theory.

Market Trends

The first rule provides that there are three types of trends that can be spotted in a market. They include primary, secondary, and minor trends. Each trend is defined by its duration instead of the direction in which they lead the market.

Primary trends can be upward or downward but last the longest, ranging from months to years.

Secondary trends often move opposite to the primary trend, lasting anywhere from a few weeks to a few months.

Minor trends or Short swings are the least significant market variation because of their fickle nature. They can last a few hours or extend to a few weeks. Minor trends are often disregarded because they do not cause lasting changes to the market.

Source: Trading View

Source: Learn By bit

Phases of Primary Trends

The Dow Theory provides that the most significant market trend can be divided into 3 phases. The three phases differ depending on whether the primary trend signals a bear or bull market.

The Bull market is divided into the following stages:

• Accumulation phase: During the accumulation phase, the market is recovering from the preceding bear markets. The value of stocks is still generally low, but smart investors recognize that another trend is beginning and start buying into the asset. As a result, the asset price begins to grow, albeit slowly.
• Big move or public participation phase: The market has fully recovered at this stage, and an opportunity for profit is apparent. The wider public becomes more active and starts buying into the market. This stage is characterized by big and fast movements in asset prices.
• Excess phase: By the final stage of the bull market, speculation continues in the market as experienced traders begin to dissolve their positions. Unfortunately, at this stage, the average investor will continue to buy more into the asset as the trend comes to a close. The phase is characterized by a declining volume which points to the start of the next trend.

Source: Trading View

The above screenshot of an ADA/USDT trading chart shows all three phases of a Primary trend.

Essentially, all three phases of the bear market trend would oppose the bull market phases. The Bear Market is as follows:

• Distribution phase: At this stage, experienced investors notice the signs of a bear market and start to exit their positions. Market prices have dipped, albeit not significantly, but news of the decline has started circulating across the investing community.
• Public participation phase: Again, the wider market catches wind of the decline and rapidly exits investing positions. The prices fall rapidly and significantly in this stage, which lasts the longest of the three stages.
• Panic phase: Finally, the consequences of the bear market have settled in as investors have lost hope of a full reversal.

Market Reflects all News

This rule is directly linked to the Efficient Market Hypothesis(EMH), which provides that stock prices mirror new information in the market. According to Dow’s theory and EMH, the price of an asset will often reflect the associated market information. This is a result of the reaction that salient news has on investor sentiment, and so investors should be cautious of sudden market changes due to positive and negative news surrounding the market.

Indices Confirm Trends

While developing his technical analysis theory, Dow believed that the trends of one index could predict the trend in another. In his analysis, Dow paid attention to the Dow Jones Transportation Average (DJTA) and the Dow Jones Industrial Average (DJIA), market indexes representing two economic sectors that were most significant at the time.

At the time, both sectors were connected because transportation, particularly railroads, was linked to industrial activity. So Dow’s theory proposed that the trends in one index should be somewhat replicated in the other. And so, if there was an upward trend in the DJIA, an upward trend in DJTA was soon to follow. Dow also proposed that when the indices moved in opposite directions, it pointed to a reverse in market trends.

In modern times, however, looking out for the correlation of those two indices does not hold much weight as there are other methods of delivering goods. Additionally, there are lots of goods that do not require physical deliveries. Alternatively, some investors have begun to compare indices like the S&P 500, NASDAQ100, or FTSE 100, to determine the direction of the market.

Volume Is Significant to Market Trends

According to Dow, where price movements point to the onset of a trend, such a trend must be confirmed by the trading volume. A high trading volume often means that the movement represents a true market trend. This is because when a majority of traders buy into certain positions, the stock price will move significantly in a uniform direction, signifying the onset of a primary market trend.

A Trend Continues Until Definitive Cues Signify a Reversal

Dow recognized situations where a market temporarily moved in the opposite direction of the dominating trend. The Dow’s Theory provides that a market trend will continue until a definitive reversal occurs. Dow’s theory encourages traders to be cautious in identifying reversals until they confirm that it signifies a new primary trend.

How to Apply Dow Theory to Crypto Markets

Having been established more than a century ago, modern investors and analysts question the relevance of the Dow theory in modern financial markets, especially cryptocurrency.

In recent times, not all of the six basic principles will apply. For example, the rule regarding the correlation between the DJIA and DJTA has become obsolete. Tech stock indices like the NASDAQ100 have replaced the DJTA index.

Crypto and other modern financial markets are often decoded using complex trading mechanisms. Still, the underlying logic of the Dow theory remains investor (human) sentiment, a factor that remains constant over the years.

In applying the Dow theory to the crypto market, there are a handful of things investors need to note:

• Primary and secondary market trends
• the phases of primary trends, both bullish and bearish

Primary and Secondary Trends

According to the Dow theory, primary trends last the longest and could be bearish or bullish. Finding a primary trend on a crypto market chart should be the first step in applying the Dow theory. A primary trend in the cryptocurrency market would include high swings and follow one direction.

On cryptocurrency charts, identifying a primary trend is easy because the market is young, and most cryptocurrencies begin with a bullish bias. Dow theory advises investors to only make their trades in line with primary trends and to wait out the secondary trend.

Accumulation and Distribution

After identifying the primary trend, investors need to consider volume data to identify the phase of the primary trend and determine a profitable entry point. Subsequently, they also need to know what point to sell their assets and exit their trading positions.

Is the Dow Theory Reliable?

While the century-old theory has proved useful to many investors, it does have its weaknesses. For example, a successful application of the Dow Theory in predicting price direction needs at least two years’ worth of data. Some cryptocurrencies on the market lack that much data. What’s more, the industry is incredibly volatile, with massive hikes and drops in crypto prices.

The more reliable method to apply the Dow Theory to crypto market analysis would be to incorporate other technical analysis tools such as a moving average, MACD, or stochastic oscillator. If a significant number of these indicators point in the same direction, the chances of the price following that path are higher. All these tips, along with a solid trading plan, will increase the chances of success at trading and investing in cryptocurrencies.