Dow Theory: The basics

By October 20, 20216 minute read
Dow Theory: The basics

Note: This blog is written by an external blogger. The views and opinions expressed within this post belong solely to the author.

Dow Theory is a framework for technical analysis based on the writings of Charles Henry Dow on market theories. Dow was the founder and editor of The Wall Street Journal and the co-founder of Dow Jones & Company, America’s leading stock index.

Dow Theory was developed after Charles Dow’s death by other writers who collected and refined his ideas after his passing. In the modern cryptocurrency market, Dow Theory is one of the key fundamentals used in technical analysis.

So what is the Dow Theory?

As a general rule, Dow Theory applies to all financial instruments and commodities traded on the open market. He went on to refine his ideas in a series of articles in The Wall Street Journal, which he started in 1889.

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Dow, Edward Jones, and Charles Bergstresser created Dow Jones & Company in 1882. The newspaper’s main purpose was to give fair stock market analyses. Moreover, Dow and his colleagues aimed to build a market average of selected stocks in the transport industry that later became the Dow Jones Transportation Average (DJTA).

Dow created the Dow Jones Industrial Index in 1896. (DJIA). The DJIA now serves as a powerful indicator for the US stock market.

Dow Theory is mostly used to determine trend direction by monitoring the DJIA and DJTA indices. The trend is considered positive when both indexes move in the same direction, making higher lows and higher highs.

According to Dow Theory, a market is in a downturn if one of its averages breaks below a previous significant low, and other averages follow suit.

Throughout its more than 100-year existence, many people have contributed to the Dow Theory we see today. This approach is still used today to trade cryptocurrencies and their derivatives.

The core basics of Dow Theory

The Dow theory is described as a collection of rules that investors use to gauge the market. When the market is bullish or bearish, these six Dow Jones tenets can help investors make more informed trading decisions.

The Market Discounts Everything

According to the Dow theory, which is based on the efficient markets hypothesis, the current asset price will represent all of the publicly available data. If an individual doesn’t evaluate any of the publicly available information, the crypto asset’s value will still include all of the information. Even if one doesn’t consider future potential or even possible failures, they are discounted as risk premiums – even before the specifics have been made public.

There are many who believe it’s similar to the chicken-and-egg problem, making it the most controversial concept in the Dow theory. Whether the prices reflected are reactive or proactive cannot be determined with certainty; it cannot be determined if the market is already aware of the information or if it only reacts to the news.

The market moves in three ways

Based on the length of these trends, Dow classified trends into three categories:

  • Primary trends: Trends that have a timeframe of one year or longer. This is often referred to as the Primary Trend.
  • Secondary trend: It is the one that is shorter in duration and moves in the opposite direction of the major trend. It lasts anything from three weeks to three months on average.
  • Noise/Minor Trend: A trend that lasts for less than three weeks is called a noise trend.

The BTC-USDT chart from 2017 identifies such trends. An informed investor will be able to get the most out of each trade by knowing when to enter and quit a position based on these different trends.

Three distinct Phases define primary trends

The 3 phases will comprise a primary trend.

Accumulation: Experienced investors perceive that an asset’s valuation is low and that there is a negative sentiment surrounding it, and they begin buying. The trend begins to gain momentum gradually.

Public Participation: The general public will soon seek to capitalize on the trend but will not make as much as the early adopters.

Distribution: Traders look to maximize their profits through speculation, but first-time investors recognise that the trend is fading and consequently exit the position. Eventually, the trend reverses.

Unless there are clear signs of reversal, trends continue.

According to the Dow theory, primary trends will persist despite temporary noise in the reverse direction. Expect no change unless there is a conclusive indicator clearly showing a reversal.

Applying this aspect of the Dow theory to cryptocurrency trading – refer to the 2017 Bitcoin – Tether chart above. Despite brief swings and a secondary trend, the primary trend is clear and prominent.

Indices Confirm with Each other

According to this principle, the Dow’s industrial and transportation-related averages should move in the same direction.

The underlying concept is that indices derived from the production and sale of goods are correlated. For instance, when a transporter is required to transport manufactured goods from a warehouse if transporters stocks deteriorate, industrial stocks will deteriorate as well.

Ideally, the industrial and transporters averages should move in sync to confirm a stable market sentiment. Moreover, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period. This is referred to as a divergence, which is viewed as a possible forerunner to a market trend reversal.

Taking this example a little forward – Businesses do not rely on railroads for transport in today’s world. Instead, they use air, sea, and other modes of transportation. Even technology giants such as Microsoft, Apple, and Google may not involve such deliveries. Similarly. In the case of investments, investors can use alternative indices such as the S&P 500, FTSE 100, or NASDAQ 100 to determine the market’s direction. The same goes with Crypto as well.

Volume Must Confirm Trend

If the price moves in the way of the primary trend, the volume of trades must increase; if the price moves against it, the volume of trades must decrease. A low volume indicates that the trend under analysis is weak.

This is a fundamental concept in technical analysis, and numerous concepts, including the Fibonacci Retracement tool, are based on the Dow theory.

Noted drawbacks of Dow Theory

Dow Theory requires a minimum of two years of data in order to forecast price direction. Reliable historical data is difficult to come by in the cryptocurrency market. Furthermore, even if such data is learned, its reliability is questioned, as cryptocurrency markets are notoriously volatile.

Another point to consider is how difficult it is to define the current market trend’s consistency. According to Dow Theory, even if a price is approaching a swing low, an uptrend remains valid. Similarly, if the price is at a swing high, a downtrend is considered active. Thus, if one considers only higher bottoms and lower tops, Dow Theory can be followed in the long run. What falls under the primary or secondary trend is not clearly defined.

Investors generally regard support and resistance levels as critical, with bulls typically initiating buy trades at support and bears initiating sell trades at resistance. When a support or resistance level is broken, the position is reversed: support becomes resistance and vice versa. When a near-term swing level is broken, the S/R levels reverse their positions in Dow Theory, but this is only one aspect of support-resistance trading.

As a result, investors should substitute their charts with additional elements to increase trading probability. Dow Theory remains valid and effective in the cryptocurrency market when combined with other trading tools such as a moving average, MACD, stochastic oscillator, or even VWAP for more efficient trading. If multiple indicators point in the same way, the price will probably follow.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.
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Rony Roy

Rony Roy

Rony Roy is an electrical engineer who turned tech author in the Cryptocurrency space. He got block-chained in 2012 and fell in love with tech and its use-cases and has been writing his way through problems since 2016.

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