Lesson Learning objectives : What is the Market Theory ? How it applies to Cryptocurrencies ? This lesson address these important topics in a simple and efficient way, to allow the participant to understand quickly how the Market Theory and the Market Cycles applies to cryptocurrency trading
Note : Click on the images at any time to enlarge them
Dow Theory (Market Theory) Description
Dow Theory is considered by most traders to be the basis of Technical Analysis. Created from the writings of Charles Dow (1851 – 1902) as he observed the Dow Jones Transportation Average and the Dow Jones Industrial Average. Only after his passing were his editorials compiled and represented as Dow Theory and its applications as a trading system by Hamilton and Schaefer.
Let us have a look at these concepts (tenets) and see how they can relate to cryptocurrencies.
Dow Theory Tenents
Tenet 1 : Markets Have 3 Trends
Dow defined an uptrend as a period of time where the price of the cryptocurrency creates new higher highs. With the price making lower lows given a period of time as a downtrend. Dow Identified that smaller trends existed in the major trend, he called these trends secondary tends and noticed within these secondary trends existed minor trends.
Understanding the major trend allows traders to identify the secondary trend and thus adopt a stance on their trading position (I.e The price is going up but as the trend is bearish, I will sell the rally).
1: Primary Trend (Red line): Is the long term trend and Identifies where the market is in its cycle.
2: Secondary Trend (Blue line): The secondary trend is a shorter trend within the primary trend which moves in the opposite direction without reversing the primary trend.
(In the graph below we can see the Primary Trend (Red Line) and the Secondary Trends (Blue Lines) on the Total Cryptocurrency Marketcap Chart.)
3 : Minor Trends (Green Line): Minor price trend changes will be characterized by being the shortest of the three trends. They are represented by a short price change in the opposite way.
(If we zoom in on the above graph we can see the Minor trends (Green Lines) more clearly. The left most minor trends (downtrending) are short lived moves opposite the primary trend, alternatively as the secondary trend takes shape we see minor trends (uptrending) as short lived moves against the secondary trend.)
Tenet 2 : Markets Have 3 Phases
The market trends have 3 phases that will repeat themselves over time. Lets look at Bitcoins Price action to identify these phases.
Accumulation: This is the phase where “smart money” begins to accumulate their position and typically follows a large secondary trend against the primary trend. In cryptocurrency, much like penny stocks, this secondary trend can retrace 30-70% of its previous all time high.
In this phase Bitcoin is not appealing to less informed investors, whom think the price is likely to fall more or not recovery at all. As “smart money” are buying against the current trend, they are in the minority, the price does not move much and stays within a range.
Public Participation Phase: In this phase public investors follow the smart money and trend traders begin to enter the market. This causes the price to steadily climb.
Excess /Distribution Phase: The Smart money Investors start to sell and take profits. As there are now a large amount of Bitcoin holders, there are now fewer buyers in the market. As such the market begins to retrace, this then leads to panic as the latest group of investors react to the market negativity.
Panic / Cycle restart: After the excess phase and the panic phase has retraced the price back to the primary trend. Once tested and still found to be a strong trend then accumulation phase will begin a knew causing the price to go sideways.
Tenet 3 : The Markets Are Efficient
There is a lot of debate and alternative theories about the efficiency of markets, with one side believing how Dow did. In that markets are efficient and reflect any and all news about a given asset. Whereas others believe that markets are inefficient and do not represent the real price.
Dow believed markets were efficient and that when new news was released investors would rush to buy or sell the chosen asset.
The reality as we believe it to be is that investors are not fully aware of all the given information and thus can not always trade optimally. It is the objective of the trader, when presented with new information, to ask themselves, Is this news reflective in the price I see today.
A number of times people incorrectly attribute certain events to price movement, although you can not predict when news arrives, Ta allows us to see how investors behave when confronted with positive or negative news, this is usually reflected in a cryptocurrencies volatility over time.
Tenet 4 : Market Averages Must Confirm Each Other
In Dow’s time there were only the two indices, namely the Dow Industrial Average and the Dow Railroad Average. Since then traders have been able to access many more indices, the S&P 500, Nasdaq and the cryptocurrency market to name but a few.
Dow noticed that the two averages would reflect one another, when they diverged he noted that a reversal in trend was approaching. This is because of the specific relationship between manufactured goods and transport (railroad average), in that if the manufacturing sector was performing well then it would stand to reason so to would the transportation companies associated with these goods.
People seek to re-emulate this tenets by comparing the cryptocurrency market to the Dow Jones or Nasdaq indices.
At present there is currently no correlation between the Dow and Bitcoin with the study by Datatrek concluding only a 33% correlation rate.
Tenet 5 : Trends Must Be Confirmed By volume
Volume precedes price and thus Trends are confirmed by volume. With volume increasing as price increases and decreasing when declining.
Tenet 6 : Trends do not change until there is clear evidence of a reversal
Markets can temporarily move opposite to the trend before returning in the original direction. As such the current trend is given the benefit of the doubt until such time as clear signals have been shown for a market reversal.
Deciding if the current price action is a market reversal or temporary move can be a difficult task. Traders employ various trading indicators (covered in course 2) that can help interpreted various market data. However different traders derive different answers from the same chart, which is where the saying, charting is an art and not a science comes from.
Practical Exercise (Optional)
With the below TradingView tool see if you can identify:
- The 3 Market Trends
- The 3 Market Phases
(Note: Use the mouse wheel to zoom in and out and the left click to grab and move the graph. It will change size depending on available space to fit the information. )