Dow Theory is a technical analysis framework aimed to help traders make weighted trading decisions and to predict price moves. Despite being over a hundred years old, the theory is a good analysis tool for the present-day crypto market. In this article, we’ll take a look at how it works and consider some use cases.
History of Dow Theory
Charles Henry Dow, an American journalist who founded The Wall Street Journal, developed this theory to provide unbiased market analysis to the public. Together with other financial reporters he founded a financial newspaper in 1882 and called it “Dow Jones & Company.”
Then, Dow created an average of transportation stocks that later became the Dow Jones Transportation Average (DJTA). Later on, the first average known as the Dow Jones Industrial Index (DJIA) saw the light of day. Today, the DJIA is a highly reliable indicator of the US economic health.
Dow Theory primarily uses the performance of the DJIA and DJTA to predict existing market trends. The trend is seen as bullish if the two indices move in the same direction, making higher lows followed by higher highs.
Alternatively, Dow Theory says that a market is in a downtrend when one of its averages falls below a prior important low, and this is followed by a similar drop in other averages.
The cryptocurrency market is now in its infancy and it’s pretty much like the stock market used to be a hundred years ago. At that time the stock market was similarly volatile, unpredictable and unregulated.
While high-frequency trade algorithms power financial markets today, the human brain is still at the heart of market formation. Hence, Dow Theory can still be used to analyze cryptocurrency markets, though it should be approached differently.
According to Dow, market trends can be classified into three types depending on their duration:
- A primary trend, which is the beginning of a trend that lasts for one, two, or three years.
- A secondary trend that moves in the opposite direction as the primary trend. The trend lasts between three weeks and three months.
- Short swings, or minor trends, are price changes lasting fewer than three weeks.
The above is a BTC/USD year-to-date chart with a bullish primary trend.
The primary trend includes three following phases:
- Accumulation. In this phase, the value of an asset deteriorates amid a bearish bias. Savvy traders start buying an asset before the price starts to rise.
- Public participation. The general public joins the trend in this phase. However, they get far less profits compared to investors buying in the first phase.
- Distribution. This is when first-phase investors realize that the trend is about to end and it’s time to close their positions. They exit the market, with the trend starting to reverse.
News events affect asset prices
The current price of an asset reacts to all publicly available news. An asset will still follow the sentiment arising from the latest news events, no matter whether we analyze the information or not. As soon as salient news is released, cryptocurrencies’ prices rise or fall instantly, depending on the impact it has on the market .
In large part, crypto’s extreme volatility is due to its reputation-based value. This implies that a sudden negative report can bring a coin down or positive news can send a crypto asset price higher. However, a price response is not determined by the event itself but rather by the first reaction of market players.
Below is an example of the BTC price plunge following the report of El Salvador’s declaration of Bitcoin as legal tender. Although the immediate reaction was negative, the delayed effect was positive.
Among other examples, Bitcoin has been enjoying an uptrend after the first ETF linked to its futures price started trading last month. Overall sentiment is bullish, with markets hoping that new ETFs in crypto will arrive. Meanwhile, Australia’s regulator approved spot ETFs in BTC and ETH last week, in a sign of growing confidence in cryptocurrency.
Additionally, JPMorgan renewed its forecast for the Bitcoin price to increase to $146,000 in the long run, indicating that it is more like digital gold than ever before.
All these latest reports and statements add to the overwhelming belief that the primary trend in cryptocurrency is bullish.
Trading volume behind a primary trend is always high and it decreases in case the price moves in the opposite direction. Higher volume means that a large number of traders are joining the trend, thus contributing to its stability. Conversely, low volume amid a primary trend means that there’s weak market activity and lower chances of trades.
Dow Theory says that a primary trend will exist until another major event changes the market sentiment.
Market players open trading positions towards the primary trend and ignore an opportunity to trade against it as can be seen in the chart below.
Primary and secondary trends in crypto markets
To start off, investors need to identify the primary trend. Since the crypto market is still rather young compared to the traditional markets, it’s quite easy to predict a bullish trend with most new coins.
According to Dow Theory, we need to make trades within the primary trend only. If you spot a secondary bearish trend, you need to wait for it to end.
To get the best entry point, traders need to make sure that accumulation and distribution phases are supported by trading volume.
In the above daily BTC/USD chart, the primary trend is bullish, the market has entered the accumulation area and the distribution phase is over. A new swing high can be seen in the accumulation area, reversing the bearish secondary trend. Trading volume backs the primary trend.
Although crypto markets involve a great deal of volatility, Dow Theory can serve as a useful analytical tool if you add other elements to your charts like MACD or moving average. To have a better understanding of the market sentiment, you can group similar assets like BTC and ETH, and watch their price movements.
And of course, digital assets are highly sensitive to crypto-related news, so you should keep abreast of the fundamentals to make sure whether they support the primary trend or not. The price is more likely to follow the side if multiple indicators and fundamentals are trending in the same direction.