The Basic Principles of the Dow Theory
Dow Theory is an essential framework for understanding the behaviors of financial markets. Originating from the ideas of Charles Dow and his students in the 19th century, its significance remains intact to this day.
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The Six Principles of Dow Theory
Dow Theory is built on six core principles, which lay the foundation for analyzing and interpreting market movements.
1. The market is prone to fluctuations as it is persistently influenced by the evolving news landscape. Significant political and financial events, whether they occur within the issuer companies or on the global stage, invariably affect the price of financial assets. Yet, predicting market trends solely based on news can be imprudent, as they often result from internal manipulations.
A case in point is the FTX exchange downfall, triggered by an article on CoinDesk. The domino effect it set off led to unparalleled regulatory pressure from the U.S. on the digital sector, causing asset prices to plummet.
2. Market trends differ in duration: primary (long-term), intermediate, and short-term. Primary trends can last anywhere from a year to several decades. Intermediate trends persist for less than a year, and short-term trends range from several minutes up to a month.
Within each trend, distinct sub-trends exist: upward (bullish), downward (bearish), and flat (lacking a clear direction). Each possesses unique characteristics, hence they necessitate different analytical approaches.
Given that the crypto market history spans just over a decade, analysts tend to base their forecasts predominantly on internal trends. However, some experts argue that the emergence of Bitcoin, its subsequent growth, and the rise of altcoins can already be viewed as a primary global trend, poised to alter the development strategy of financial markets, including those of insurance and securities.
3. Trends typically encompass three phases: accumulation, markup, and distribution. During the accumulation phase, investors purchase assets in anticipation of a forthcoming price surge. As demand increases, prices do rise, marking the beginning of the markup phase. Eventually, during the distribution phase, investors offload assets to secure profits or reinvest in other, more appealing assets.
In the cryptocurrency market, this principle manifests in cycles, with Bitcoin dominance periods often succeeded by altcoin seasons.
4. Indices should harmonize and align. The Dow Theory maintains that price movements of individual assets should be scrutinized only within the broader context of the market trends.
For example, if the entire market is on the upswing, it may point to a possible bullish trend. However, if just a single asset exhibits substantial growth, while others remain unchanged or decrease, it may suggest a market turnaround. In the sphere of cryptocurrencies, this could also indicate a likely price surge or ‘pump.'
5. Every trend should be backed by volume. Besides price shifts, the Dow Theory takes into account trading volume and open interest, which serve as measures of trading activity and investors' sentiment. For instance, during a bullish trend, trading volume generally increases, whereas it diminishes in a flat or sideways market.
6. A trend is considered valid until multiple signs point to a shift.
As per Dow Theory, market trends usually persist far longer than investors might expect. Dow asserted that traders often make the mistake of countering the trend without awaiting confirmation from several independent indicators of a reversal.
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