Technical Analysis and the Dow Theory
The Dow Theory, developed by Charles Dow, provides valuable insights into market trends, crucial for cryptocurrency trading success. This century-old theory emphasizes recognizing primary market trends and their correlation with market indices and volumes.
With the recent boom in the crypto industry, many are exploring ways to earn from cryptocurrencies. Familiarity with technical analysis is crucial if you intend to trade cryptocurrencies.
Whether you plan to actively trade cryptocurrencies or invest in them for the long term, understanding and learning how to properly use technical analysis is essential.
What Is Technical Analysis?
Technical analysis involves utilizing historical price data to try to forecast the probable future direction of price. As a technical analyst you have access to numerous tools, all derived from price and/or volume. By studying historical price data plotted on charts, you can assess the sentiment of market participants.
These technical tools can be applied to a wide range of securities, including stocks, indices, commodities, or any tradable instrument, including cryptocurrencies.
A Brief History of Technical Analysis
Charles Dow (1851–1902) is regarded as the father of technical analysis. He served as the first editor of The Wall Street Journal. In 1882, Dow and Edward Davis Jones established Dow, Jones and Co. as a Wall Street financial news bureau.
The subsequent year, they published a two-page summary of the day’s financial news, titled the Customer’s Afternoon Letter. This newsletter included the Dow Jones Index, comprising 11 stocks: nine railroad issues and two non-rail issues.
In 1889, the partners opted to elevate their newsletter into a full-fledged financial newspaper, giving rise to The Wall Street Journal, which has been continuously published since then. Charles Dow assumed the role of the first editor.
Within the Journal's editorial column, Dow educated his readers about the stock market. It was in this column that he frequently shared his observations of stock price movements. These observations laid the groundwork for what would later be termed Dow Theory and served as the foundation of what we now recognize as technical analysis.
What Is Dow Theory?
Despite being over 100 years old, Dow Theory's principles remain relevant in today’s markets. It outlines market trends and methods for recognizing them. In 1916, Dow expanded the number of companies in his index to 20.
As larger corporations emerged in the 1890s, Dow established the Dow Jones Industrial Average (DJIA). Upon its inception in 1896, it comprised 12 corporations. Dow would record the closing price of all 12 corporations, sum them up, and then divide by 12 to calculate the average.
The original index of rail stocks included two non-rail stocks. Dow replaced these non-rail stocks with rail stocks, giving rise to the Dow Jones Railroad Average (DJRA). In 1970, when the average transitioned to the Dow Jones Transportation Average (DJTA), the rail stocks were substituted with airline and trucking stocks.
Dow observed that for a trend to be valid, both indices must be moving in the same direction, as industrial output necessitates transportation to deliver goods to customers. When industrial output rises, railways are active, and both indices should ascend.
Conversely, when industrial output declines, railways become less active, and both indices should decrease. Today, goods transportation is handled by trucking and airline companies. Therefore, the DJIA and DJTA must confirm each other for a trend to be considered valid.
Principles of Dow Theory
Dow Theory is grounded on six principles:
Price of assets incorporates all information: The market integrates all information about assets into their prices. Information regarding an asset's profit potential and competitive edge is already factored into its price.
Three primary kinds of market trends: The bull and bear markets constitute the primary trends of a market. Secondary trends of a market typically run counter to the primary ones, encompassing corrections in bull markets and rallies in bear markets.
The primary trends have three phases: The primary trends progress through three major phases. In a bull market, these phases include accumulation, public participation, and excess. Conversely, a bear market experiences distribution, public participation, and panic stages.
Market indices must correlate with each other: Signals from one market index must align with signals from another to confirm a new market trend. If one market index indicates a new primary downtrend while another signals a primary uptrend, a new market trend has not initiated. However, if both indices indicate the same upward or downward trend, traders can confirm the onset of a new market trend.
Market trends should correlate with corresponding volumes: In a bull market, market volume should increase accordingly. In a bear market, market volume should decrease over time. If market volume decreases in a bull market, it could indicate a bearish movement that may lead to a bear market.
The trend persists until a clear reversal occurs: Market trends continue until a definitive reversal transpires. Despite fluctuations in daily price movements, Dow Theory underscores that a market trend will endure until a clear reversal occurs.
Bottom Line
Navigating the volatile waters of cryptocurrency investment requires a solid understanding of technical analysis. As the crypto market continues to expand, the tools and principles derived from traditional technical analysis, such as those outlined in Dow Theory, remain pertinent.
Whether you're a short-term trader or a long-term investor, mastering technical analysis charts and principles can provide valuable insights into market sentiment and help inform your decision-making process.
By incorporating historical price data and volume analysis, investors can better anticipate potential price movements and identify trends, ultimately enhancing their ability to manage risk and optimize returns in the ever-evolving world of cryptocurrency trading.
