The Dow Theory is used to understand market cycles and despite its age it is applicable even to bitcoin.
The “Dow Theory” is one of the best known and most widely used speculations on stock market behavior around the world. It is based on the notion that financial markets have cyclical behaviors, which are repeated in similar contexts and facilitate the identification of new movements in the price of an asset. Created by the economist Charles Henry Dow two centuries ago, this theory is equally applicable to bitcoin and the cryptocurrency market.
What is the Dow Theory?
The “Dow Theory” is a set of six principles that describe the behavior of financial assets in certain situations. Now considered the framework for technical analysis, it is a hypothesis developed by Charles H. Dow in the late 19th century.
Dow was a renowned American economist and journalist, co-founder of Dow Jones & Company, where he helped create the first stock index – the Dow Jones Transportation Index (DJT).
The author proposed that there are identifiable patterns and trends in the market, which can help to know whether the price of an asset will rise or fall. In principle, these writings did not set out a theory, but they had such an impact on the traders of the time that, after his death, editors such as William Hamilton refined his ideas to produce the principles we know today.
What purpose does Dow’s theory serve in the bitcoin market?
The principles of “Dow Theory” are useful for traders to understand the cycles of financial markets, and therefore the cryptocurrency market. If a trader knows that there are various trends (primary, secondary and minor) he can assess more objectively whether it is in his best interest to enter the market at a given time or, rather, wait for a more favorable trend change to occur.
Also, knowing that the market enters different phases in the course of a trend, taking into account this theory, traders can speculate with the price of the asset in a more conscious way.
The “Dow Theory”, moreover, lays the foundations of technical analysis, a fundamental discipline that serves cryptocurrency traders to forecast market behaviors. In this way, a trader can identify the main trend of a cryptocurrency, develop trading strategies for his operations and mitigate the financial risks that his trading may present.
The principles of Dow theory
As mentioned above, Dow theory is composed of six basic principles. These assume that, in most cases, the market will always follow a series of patterns that influence the price of the asset. In this section we will look at each of these principles:
Price discounts everything
One of Charles Dow’s main propositions is that all the information that influences a market is reflected in the price of its asset. This principle deduces that every event that has affected the value of a cryptocurrency in the past, the present or that may affect it in the future will be recorded in the daily price variations of the asset.
With this principle, it is suggested that those who wish to analyze the market and forecast future trends need only track the price of the cryptocurrency where its actual value is reflected. An example of this can be the halving of Bitcoin. The price of BTC is influenced months before this periodic event and usually rises, by market expectation.
The bitcoin price reflects how much impact the news has on the demand and supply of the cryptocurrency. In this way, traders can speculate whether an event, activity or network feature has a greater or lesser influence on the value of the asset.
Markets have 3 movements
Charles Dow proposes in his theory that the market has three types of movements, which are divided into primary, secondary and minor trends. Primary trends last a year or a little more and classify the market in general as bullish or bearish. In other words, they indicate whether the price of the asset has been mostly upward or downward.
Within the primary trends derive secondary trends that last for a few weeks or months. These also describe upward or downward price movements but, most of the time, they are actions that indicate correction or consolidation towards a specific price.
Minor trends, finally, last for days or at most weeks. They are unimportant variations if we look at them on a broader level, as if they were “noise” in the market, but they can be of interest to traders who operate in short positions or do scalping.
They are also 3 phases of the market
Dow’s theory also proposes that markets have 3 phases, meaning that within an uptrend or downtrend there are a set of actions that determine specific periods. In this sense, Dow suggests that markets are cyclical in nature, and that certain patterns are replicated over time determining how supply and demand work.
For the formation of an uptrend in the price of a cryptocurrency, the market has to go through three individual phases, known as accumulation, public participation and euphoria.
Accumulation: In this period early investors, who may be those with first-hand information, start investing in the cryptocurrency. They may be whales or veteran traders who plan to buy a large number of cryptocurrencies to profit from it later.
Public participation (or dilation): During this phase, traders who are on the trail of new favorable trends begin to enter. The market has been reacting towards an uptrend due to the accumulation of early investors, so more and more people join in buying this cryptocurrency hoping to generate profits.
Euphoria: Euphoria is the highest point of the uptrend, as it is the moment when the upward price movement has been consummated. Because the cryptocurrency price is at its best levels, more and more traders join the market for fear of missing out on the opportunity to generate profits (FOMO).
The downtrend starts to form exactly after the euphoria phase, because when more and more traders start to join, a distribution of value occurs between those who accumulated cryptocurrencies and those who now want to buy these cryptocurrencies. As in the bull market, in a bear market there are also 3 phases:
- Distribution: it marks the end of the bullish mountain and the “bull” market. Because a large number of buyers enter, the most avid investors who entered the accumulation or public participation phase begin to sell. The presence of sellers increases and the trend reverses downward.
- Public Participation: Similar to the public participation of the uptrend, the difference is that in this phase the market has a negative feedback. The volume of sellers exceeds buyers, the price is down and pessimism among traders increases.
- Panic: Fear has dominated the market, and most investors act accordingly. In this phase, the most inexperienced traders may sell at any price, regardless of the losses that this entails.
When the panic subsides and prices reach their minimum, there will always be traders who are willing to buy with a view to generating a return in the future. This will call for progressively more participation until the accumulation phase of the uptrend returns. In other words, one complete market cycle has ended to allow another to begin.
Trading volume confirms the trend
Market volume matters. It matters a lot. This was Charles Dow’s view and it is now being affirmed by a number of market participants. The amount of trading being done at any given time is a very important indicator of whether a trend will continue or is short-lived.
A strong trend – whether bullish or bearish – is always accompanied by a high trading volume. The higher the trading volume, the greater the chances that the market is reflecting a price movement that will be sustained over time. When volume is low, on the other hand, the price action may be short-lived.
When the trend is mostly upward, trading volume should be high if the price is rising and low when there is a fall. In the case of downtrends, trading volume is expected to increase when the price is falling and decrease when the price is rising. Thus, traders can conclude that volume always keeps pace with the trend.
The cryptocurrency market is constantly changing: the price goes up and down every second. However, we know that a primary trend is maintained over the course of several months. That is, it is a price movement that will dominate an entire season.
However, primary trends also come to an end, and identifying them can be tricky. Charles Dow proposed that a trend remains in force until all market data shows that it has definitively changed. That is, any reversal in price is under suspicion until it is confirmed that the new trend is here to stay.
For example, let’s imagine bitcoin is in a primary uptrend. In that case, a pullback of several days does not imply that, from now on, the trend has changed to bearish. The trader will have to analyze the next market behaviors, as this pattern could change or hold over time.
Only when the downward price movement is predominant, then it can be said that the market entered a down season (bear market). And, to expect a new bull cycle, traders should subject every price rise to the same scrutiny before ensuring that the market returns to green numbers.
Also known as the principle of correlation between indices, confirmation points out that a primary trend observed in one market index can only be confirmed if it also appears in other indices. In other words, it proposes that markets interact and depend on each other, so that a price increase in one product, stock or asset will also have implications for other related sectors.
This principle is one of the most contested today, as many traders consider it to be outdated. Charles Dow based this idea on his analysis of the Dow Jones index (DJT) and the industrial average.
Referred Binance Countries
Currently, although there are moments of high correlation between markets such as cryptocurrencies, stocks and commodities, the truth is that they do not necessarily react in the same way at all times. Dow based his thesis on the interaction and possible dependence between assets, which now does not occur in the same way.
Within the cryptocurrency market, however, there is usually a clear correlation: most coins tend to adapt to the dominant trend of bitcoin, the asset with the most capital and dominance of all cryptocurrencies.
Once you have understood the cyclical behavior of the markets, you could delve into the particular case of bitcoin. Therefore, we invite you to delve deeper into halving, an element that affects the price cycles of the main cryptocurrency in the market.
For more information on trading and other important concepts of this industry, the Cryptopedia of CryptoNews has dozens of articles that may be of interest to you.