How Can I Use Dow Theory To Predict Crypto Prices?
Dow theory is a theoretical framework for technical analysis that helps crypto traders spot price trends and predict their further direction. Although the theory originated in the early 20th century, it’s still a useful tool that helps thousands of investors predict crypto prices. Let’s see what the Dow theory is built on and how it can help you increase your trading income.
American Stock Market and the First Price Movement Model
Charles Henry Dow was an American journalist who founded the Wall Street Journal in 1889. He wasn’t the author of the Dow theory in itself — rather, he used the Journal to make a series of publications with his notes on market analysis. Several years after he passed away, his colleagues put all the materials together into the Dow theory as we know it today — one of the world’s first market behavior models.
Charles Dow made his observations at the turn of the 20th century — the time when the American industry was surging. However, there was a lack of methods to describe this growth, and this is how Dow came up with the idea of indices. He introduced two of them:
- DJIA — Dow Jones Industrial Average, which included America’s largest manufacturing companies, and
- DJTA — Dow Jones Transportation Average that comprised the list of the biggest U.S. transportation, shipping, and railroad enterprises.
The interaction of these indices helped Dow predict market movements: when DJIA and DJTA moved in one direction, the existing trend was bound to continue; whenever they crossed, a reversal was very likely. In the 21st century, these indices are still relevant and reflect the performance of manufacturing and shipping businesses in the USA.
Does a Stock Price Theory Work in the Crypto Market?
The crypto industry is as young as the stock market back in the days when Charles Dow observed it. This is why they share the same traits: crypto is just as volatile, unpredictable, and unregulated as stocks in the early 1900s.
Mankind has invented quite many sophisticated technical analysis tools by 2022, but one thing underlying the market behavior remains unchanged — human psychology. The Dow theory helps us understand it to a certain extent. Now, let’s see how the framework can be adapted to analyze the crypto market.
Dow Theory Tenets
Six principles, or tenets, form the basis of the Dow theory. Let’s consider each of them.
1. There are 3 types of market movements based on their duration
The Dow theory divides market trends into 3 groups by their duration and impact:
- The main movement is the longest one and lasts for at least 1 year. Any investor or trader should orient their portfolio towards this trend: as long as they go in line, the investments bring maximum profits.
- Medium swings last at least 10 days, but no longer than 3 months. The direction of this movement is the opposite from the main movement and can retrace from 33% to 66% of its price gain.
- Short swings last between several hours and 2–3 weeks. They are directed opposite from the medium swings.
At this BTC/USDT chart, you can see a bullish main movement with medium and short swings:
Image source: TradingView
2. A trend comprises 3 phases
In a long main movement, there are three phases, or trends, that reflect investors’ activity:
- Accumulation. This is where the trend starts: the prices are low as set by the preceding bearish movement. At this stage, experienced investors understand that the asset is undervalued and purchase it.
- Public participation. After the seasoned market players, here come regular investors that see clear signs of the growing market movement. This strengthens the trend, but the traders who joined here will gain less than the early birds.
- Distribution. Savvy investors from the Accumulation phase realize that the end of the trend is coming, and this makes them sell their positions. Their exodus pushes the trend to reverse.
3. Asset prices reflect news events
Any market is significantly influenced not only by objective events but also by the emotional response that they cause after being broadcasted in the media. Asset prices react to news events almost instantly, and this reaction reflects all the expectations and fears that market players have in this situation.
Crypto prices are largely based on reputation — and news that affects the impression over a certain coin has a big impact on its price. This is one of the reasons why cryptocurrencies are volatile.
In this chart, you can see how Bitcoin reacted to the news that El Salvador would make it legal tender. After the negative immediate response, we witnessed a positive trend:
Image source: TradingView
4. Indices must confirm each other
Charles Dow analyzed the stock market based on the performance of Transportation and Industry Averages — DJTA and DJIA. When they went in the same direction, the trend would continue, and their crossing would signify that the reversal would manifest soon.
Indices of a similar kind have started to appear in the crypto market lately. S&P was one of the first ones to start tracking different sets of cryptocurrencies to point out the benchmarks for the largest coins’ performance. The selected assets were picked based on their liquidity and market cap.
5. Trading volume must confirm market movements
Any main market movement should be confirmed with the surged trading volume. Here’s why: when a big number of investors start reinforcing the trend in the Public Participation phase, they massively purchase the asset, which should be reflected in the volume numbers. If the trading volume is decreasing, that means the trend is weak and a downward market movement is very likely.
6. The trend should continue if no signs prove otherwise
Investors should keep their positions and assume that trend is to continue if there are no signs of an upcoming reversal. Such signs may include a decreased trading volume and crossing indices.
In the chart below, see how each price increase is accompanied by a trading outburst, and the volume doesn’t come back to the basic level between the peaks:
Image source: TradingView
Dow Theory Tenets in Trading
Six principles of the Dow theory help traders structure the market information, identify the moments when bullish and bearish movements start, and make decisions on buying and selling cryptocurrencies.
Before purchasing any asset, make sure you’re at the beginning of an upward trend (or at least in its distribution phase). The movement should be confirmed by increased trading volume or correlated indices.
Once you’ve purchased the coins and entered the trend, keep your position and don’t sell it before you see signs of a reversal. Keep in mind that medium swings can slash up to 66% of the main movement gains — this will help you preserve your position and not quit at a bad moment.
The Dow theory is more than a century old, but it’s still a good tool to analyze crypto market price movements. For more considered decisions, use it together with other kinds of technical analysis such as moving average or MACD. Putting together correlated assets like BTC and ETH and tracking their performance is also a good way to understand the market. Over, remember a simple rule that may help you make much more profits: the more tools you use and the more factors reinforce your decision to buy or sell, the better are your chances to make a correct guess about where the market goes.