The Dow's Theory

On January 31st,1901 Charles H. Dow compared the Cryptocurrency Market to the tides of the ocean when he wrote in the Wall Street Journal  "A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the Cryptocurrency Market."

Why is Dow Theory important?At it’s core Dow Theory is a theory about how price trends and over one hundred years later, it forms the basis of most technical analysis used in day trading and investing today. Ideas like uptrends, downtrends, support and resistance got their start from Dow Theory.

The 6 Tenets of Dow Theory
The 6 tenets or principles that would be applied to a Dow theory portfolio are as follows:

1.The market discounts everything:

This Dow theory principle has been taken from the efficient market hypothesis. It says that all available information is already reflected by the current price from company earnings to macro economics. This is also the philosophy of technical analysis but is the antithesis of fundamental analysis and behavioral economics.
In other words, the prices of stocks and indices reflect all available information, and the only information that cannot be reflected is that which is unknowable. This is known as the Efficient Market Hypothesis (EMH).

2.There are 3 kinds of market trends:
These three types of trend are split by the length of time they occupy.

Primary trends - last a year or more and are the major market trends. They can be bull markets (price travelling up), bear markets (price trending down) or sideways ranges.

Secondary trends - last a few weeks or perhaps months and usually counter-trend corrections, where the price moves in the opposite direction to the primary trend.

Minor trends -  last less than three weeks are the hunting grounds for day traders but considered noise by long-term investors.

Dow theory highlights that primary trends tend to last for one year or more. They dictate whether a market is bullish (upward moving) or bearish (downward moving). Secondary trends are the corrective moves within a primary trend. They typically last between three weeks and three months, and lead to Cryptocurrency Market corrections (a drop in stock prices) in a bull market and rallies (upticks in stock prices) in a bear market. Finally, there are minor trends that only last a matter of days and which are largely "market noise", in other words, unpredictable short-term fluctuations in stock prices.

3.Primary trends are split into 3 phases:

The three phases are dictated by what the price did previously and the role of the ‘smart money’ and the general public. The three phases are given slightly different names depending on whether it is a bull or bear market.
A bull market will start with an accumulation, then move to a public participation phases and finishes with an ‘excess’ phases. A bear market starts with a distribution phases, then a public participation phases and then a panic phase.It is always the smart money buying (accumulating) assets after a big decline, ready for the next bull market or selling (distributing) assets after a big move up ready for the next bear market. Once the price reverses, the general public follow the momentum and after a big move, those buying in greed at the top or selling in fear at the bottom are left ‘holding the bag’.

4.Indices must confirm each other:

Charles Dow created the Dow Jones Industrial Average and the Dow Jones Transportation Average and would use these two indices to confirm each other. These days investors will apply the same concept to different national stock indices like the Dow Jones (DJIA), the S&P 500 and the Nasdaq 100.
Employing a single index cannot confirm a market trend. Hence different indices and market averages should be put into operation to give an exact picture of market trends.Dow used two indices, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the supposition that no bullish or bearish trend could take place until both the averages provide the same signal. Additionally, a past trend gets exhibited when the two averages moved in the opposite direction.

For example, if one index moves up to a new 52-week high, but the other index remains below that high, then the bullish breakout in the first index is deemed not as strong and susceptible to reverse. Once the second index makes a new 52-week high, then the price action is seemed to have wider breadth and more likely to continue upwards. Vice versa for a move to new 52-week lows.

5.Volume should confirm the price:

This is still the main way that volume data is used today. As a reminder, volume is how many trades took place or the value of the trades that took place over a certain period of time. Volume on a price chart will normally be plotted as a bar chart beneath the price plotted as a line or Japanese candlesticks.
The most volume comes from the smart money that controls billions of dollars so the idea is that if the volume is rising with the price trend, then it means that the smart money is buying into the trend. However if the price is rising but the big volume happens in the declines, then it shows the smart money are selling into the uptrend in expectation that it will reverse.
Dow believed market trends get influenced by trading volumes. For example, in a bullish trend, the volume increases with the rising price, and volume falls when the price decreases. Similarly, in a bearish trend, the volume and price depict an opposite relationship where an increase in volume causes the price to fall, and a decrease in volume leads to a rise in price.
Dow saw volume as a crucial tool for confirming or refuting a market move. When a market moves on low volume, this is thought to mean a number of possible things.One such reason could be that there is one overly aggressive buyer or seller who is attempting to move the market. However, when significant price movements occurred with high volume, Dow believed that this gave a ‘true’ market view.

6.Trends persist until there is a clear reversal:

This if you like is the original ‘the trend is your friend until it ends’. The thing the Charles Dow taught us to keep in mind is that the trend will always last longer than you think. So you need to be very clear that the trend has turned before you start trading against it.
This brings about the need to explain ‘How to identify a trend’ and ‘how to identify a trend reversal’. Dow does this via the idea of peaks & troughs. The idea is very simple but can be hard to implement without extensive practise trading.Dow observed, as have we all, that market prices do not go up or down in a straight line – the trend is curvy. The top and the bottom of these curves are called peaks and troughs. A peak can also be termed a high and a trough can also be called a low. The thing to do is compare how each high compares to the previous high and how each low compares to the previous low.