Even though Dow theory was created to make sense of the traditional markets, it still holds a place in the crypto markets.
Out of the many different frameworks out there for predicting market trends, Dow theory is likely the most famous and widely adopted of the bunch.
Nearly 150 years ago, Charles Dow published his data-driven analysis of the market as a whole in the Wallstreet Journal. Not only was he a founder of the Journal, he essentially helped to create the first stock index.
It wasn’t until years after his death that Dow’s most influential ideas, six of them to be exact, were compiled to form the framework that is the Dow theory of today. Despite the proliferation of modern, technology-driven financial models, Dow theory still offers a tried-and-tested reading of the market at large.
Today, we’ll be exploring the key points behind Dow theory and how it is used in the real world.
How Does Dow Theory Work?
In its most basic form, the Dow theory can be viewed as a set of six categorical guidelines that speak to particular aspects of projective trends. Each of them can be used to observe and evaluate the market clearly and concisely. Let’s take a close look at each of Dow’s six assumptions individually.
1. The Market Discounts All But Acts of God
Often considered the Occam’s Razor of the financial world, this principle draws upon the Efficient Market Hypothesis (EMH). It states that the price and valuation of the market reflect information that is already available. If information is not yet available then it cannot be reflected in the trend.
In the context of the stock market, this implies that the average of a group of stocks is bound to have a more stable trajectory than the trend of a single stock.
Single financial entities are exposed to unsystematic risk based on their own performance. A company, asset, or stock performs well as a result of indicators that reflect back upon it. On the other hand, grouped financial entities such as a portfolio of stocks are subject to the systematic risk of the market itself.
In other words, the average performance of assets most likely dictates the trend of an individual asset’s performance. Today, we can see this in the form of market speculation, where expectations regarding a particular company are likely to affect all companies in the same group.
2. Market Trends Have Distinct Classifications
Dow theory’s second principle seeks to itemize three distinct trends that can be observed in the market. All three of these trends are based on a period of time and give insight into the future outlook. They are:
- Primary trends: Primary trends are long-term trends observed as steady tails on a graph. They represent trends that last a year or more. In almost all cases, these are considered significant market trends that have the ability to predict a market upturn or downturn.
- Secondary trends: Secondary trends are shorter but stable periods of fluctuations that can last anywhere from a few weeks to months. These trends represent brief market corrections in reaction to a particular primary trend.
- Minor trends: Minor trends are fleeting periods of instability that can last days or weeks. To the investor with the more extensive market outlook, they are considered to be noise amid the larger picture of more significant trends.
3. Indices Are Correlatively Affective
One of Dow’s key insights was drawn from his observation of the index of Dow Jones & Company. In his study of trends, Dow found that indices like the Dow Jones Transportation Index and Dow Jones Industrial Average affected each other in near-sync.
In other words, one index almost always confirms the trend of another. In a situation where you witness two trends moving apart, this can be a subtle indicator that a market reversal is on the horizon.
These days, this principle does not guarantee the same output and is subject to many of the same criticisms as Dow theory more broadly, specifically its outdated correlations.
4. Primary Trends Are Three-Phased
Charles Dow further classified the primary trend into distinct phases for market activity as follows:
- Accumulation: During this phase, market confidence is at its lowest point, with little public interest. Early investors start to accumulate assets in anticipation.
- Public Participation: Once the trend gathers momentum, small investors and the public begin to invest, thereby reinforcing the trend.
- Distribution: Towards the end of the trend, the public at large may become involved in speculation. However, by this time the trend has neared its end and all holdings are distributed.
5. Primary Trends Remain Until Reversed
Dow’s fifth principle serves as a word of caution. It states that primary trends are bound to continue until it is certain that a market reversal has occurred. For this reason, it can be hard to distinguish a secondary trend from a reversal until after the fact.
6. Market Volume Must Validate Trends
The sixth and final principle of Dow theory states that a high market volume must confirm significant primary trends. In its absence, it is difficult to ascertain the actual trend of the market and separate it from factors like speculation or manipulation.
How to Use Dow Theory in Trading
Some of the principles behind Dow theory may be somewhat past their prime. However, this pioneering theory still serves as a key foundation for market analysis.
For contemporary traders, Dow theory offers a systematic schema to follow in the face of economic uncertainty. Whether they trade stocks, forex pairs, or even cryptocurrencies, many of its principles still contribute to traders’ outlook.
When applying Dow theory, it is vital to separate out the three trends, yo recognize the primary phases, and to observe the market at large. This helps to encapsulate trading knowledge and predictions into an actionable plan for execution.
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