Crypto Academy

Dow theory

Dow theory

5 min reading

Technical analysis tools help traders to make a decision in the market. Learn more about this.

Dow theory

What’s the Dow theory?

Technical analysis briefly

Technical analysis is a universal method of analysis that applies to financial markets, stock markets, futures, options, and currencies. The basis of modern technical analysis is the Dow theory. Charles Doe was an American journalist, creator of the world-famous financial publication The Wall Street Journal and the Dow Jones Index, and co-founder of Dow Jones and Co.

History of Dow Theory

In the nineteenth century, Charles Dow was the founder and editor of the Wall Street Journal, as well as a co-founder of Dow Jones & Company. As a member of the corporation, he contributed to the development of the Dow Jones Transportation Index, the first stock index (DJT). He also described a market behavior hypothesis that is still in use today. The notion that the market could be anticipated only through the use of charts was innovative, and many 20th-century investors slammed it right away. What cannot be claimed now is that people make money in all kinds of markets using technical analysis based on Dow’s theory, supplemented with a variety of tools.

What is Dow Theory?

Charles Dow’s theory is a theory that describes the behaviour of stock prices over time. The postulates of this theory form the basis of the methods used by investors around the world, working both with the stock and index markets and with the foreign exchange market. At the heart of this theory are the studies of Charles Doe, which describe the behavior of stock prices that change over time. Such a concept as the Dow theory appeared after the death of Charles, and it was supplemented by other authors.

How Dow theory works

The Industrial and Transportation (Dow Jones) indices should confirm each other when the trend changes. If no such confirmation is observed, then there may not be a reversal. Trends should be confirmed by volume. Dow believed that a trend was confirmed if stock prices rose and trade increased with them. For a qualitative assessment of the market, it is always necessary to build a joint graphical model – a trading volume histogram on the price chart. The histogram structure includes bars of different heights. Each bar corresponds to its own trading period, which depends on the selected scale (1 minute, 5 minutes, 25 minutes, etc.). The higher the bar height, the higher the speed at which the market-maker updates the quotes. 

Each bar of the histogram corresponds to one chart figure (bar or candlestick), which determines the trading volume for the trading time (trading interval). The histograms are placed under the price chart.

The trend will continue until there are unambiguous signals of its termination. The author believes that the market will most often continue to move in the current trend, rather than change it. A trend change will occur only if there is an unambiguous signal about it: a breakout of trend lines and closing prices outside of it. There are three types of trends: primary (long-term), secondary (or intermediate), and small (or short-term). And a trend always has a direction. It can be: ascending, downstream and lateral (flat).

Principles of Dow Theory

Dow Theory consists of the following principles. A trend has three phases: accumulation, participation, and implementation. The accumulation phase is when investors start buying or selling an asset. But there are few such investors and they cannot contribute to the organization of the trend. At the stage of participation, traders begin to open deals on a new trend, which then gains strength.

And after the trend has arisen, the rush of buying or selling begins. When the price peaks, the investors close and get a good profit from it. After that, the trend starts to reverse. In the event that new traders support the trend, the trend will continue, if not, then a reversal will occur. The price takes into account everything. This means that the market price displays everything that can affect the supply and demand of the market. Indexes must be consistent. 

What is needed

The first thing you need to trade on the Dow Theory is a trading platform. Today there are a lot of companies that offer such services. Some of them even have a Demo mode that allows users to practice first. Dow theory states that certain stock indexes must be consistent with one another. This statement directly applies to indices such as the Dow Jones Industrial Average as well as the Dow Jones Transportation Index. According to the theory, the trend that has already formed and signals about its change should be confirmed by both indices. By the way, sometimes differences between the signals are allowed here, for example, one can come earlier than the other.

These principles are universal, and they must be studied by every trader who trades through technical analysis of the market since they are technically analyzed in the postulates of Charles Doe.

Formula

We would like to present you one of the possible variants for proving Dows axiom, based on the analysis of commercial structures profit on the real competitive market of goods and services, because the main goal of any commercial structure is profit and Forex is not far away from the real market of goods and services. It is known that the most obvious, simple, radical, reliable and unquestionable way to determine profit (P) is its representation as the difference between income (E) and all kinds of expenses (P):

P = E – P

Expenses (P) are variable (Pper), dependin on income (E), and constant (Ppos), independent of income:

P = Pper + Ppos

Therefore, the profit formula is usually represented as

P = E – Pper – Ppos

Using the definition of variable costs as Pper = K*D, we obtain, where K is the coefficient of proportionality, we write

P = (1-K)*D – Rpos

Expressing Profit (E) as the product of the volume/quantity of goods (V) and its selling price C, we obtain the following formula for determining profit in the traditional way

P = (1-K)*V*C – Ppost (1)

Any person looking at this formula (1) will exclaim: the profit depends on both the volume and the selling price of the commodity! And he would be right.

But, some sources shows how to derive an alternative formula for profit taking into account the provisions of the law of supply and demand, which coincides exactly with the traditional formula (1):

P = A*(Ts^2 – 2*Cp*C + Tsopt^2)/C (2)

Here, A, Tsr and Tsopt are constant coefficients calculated experimentally on the basis of actual trade data within selected data sample, where A>0 for monopolistic and A<0 for competitive markets, Tsr is market price and Tsopt is optimal sales price providing maximum profit.

Based on the absolute equality of the formulas (1) and (2), we conclude that the Dow prophecy in the form of the first axiom can be a proven theorem as it contains no other variables besides the price, and traders and market researchers can safely rely on the price analysis in their market research without being distracted by other market parameters.

Conclusions

RSI

RSI

5 min reading

Crypto investment has so many strategies. Let’s get to know one of the important tools for technical analysis, Relative Strength Index (RSI).

RSI

What is Relative Strength Index (RSI)?

History

Wales Wider, a trader, created the Relative Strength Index, which was first published in Commodities magazine in the summer of 1978. Welles later wrote a book in which he described the essence of RSI in greater detail. Actually, following the publication of the book, the relative strength indicator became popular, and world traders used it to determine the strength of the trend.

RSI indicator

To analyze the movement in the market, traders need to use some indicators and methods to analyze price impulses. One of these is RSI. The RSI indicator provides a realistic assessment of the strength of the present trend and determines the probable points of its inversion. The method was developed back in 1978 by Welles Wilder, the widely acknowledged founder of the different concepts of technical analysis.

The instrument gained its popularity largely due to the ease of interpretation and the quality of the signals it gives. The entry points that this indicator gives independently and together with other indicators show a very good risk-reward ratio in volatile and trending markets.

How RSI works

The RSI oscillator, which is exactly what it is, fluctuates in a certain range between the maximum (100) and minimum (0) values. It operates at the price change rate, displaying results in the above range. The most significant effect of the operation of the oscillator is observed when it is close to its extremes. A reading above 70 usually indicates that the asset is overbought and if below 30, it is oversold. The overbought asset is trading above its fair value due to excess demand, while in the oversold market prices have dipped below their fair value due to sales pressure. The only configurable parameter of this indicator is the period. Also, many experts recommend refraining from trading a pair when the RSI cryptocurrency indicator is in the side zones 0-30 and 70-100. 

This is because the market enters a state of overbought or oversold, which can lead to a large flow of sales or purchases, respectively.

How to use it on bit4you

A trader needs to know how to work with the RSI indicator. First, it should be installed in the trading terminal, and this can be done very easily. After that, you’ll see a menu with an offer to choose the additional indicator. Initially, the indicator has a period of 14, as well as the levels of 30 and 70. If you want to change them, you will need to click on edit. Sometimes levels are changed for such combinations: 20 and 80, 40 and 80 (for a bullish trend), 20 and 60 (for a bearish trend). You can also choose the period from 5 to 25. What you should remember is that if the number of periods decreases, the indicator will become more sensitive to the price. As a result, it will give out a lot of signals, some of which can be false.  If you set, for example, the number 25, the curve will become smooth, almost without oscillations. This is not always convenient because the signals can be too rare.  It is recommended to set the number of periods higher for a shorter time frame, and lower for a longer one.

What is needed

In most cases, the RSI is shown on a separate chart over or under the price chart. The RSI indicator shows how strong the trend is and how likely it is to develop. For the calculation or the relative force index, all you need is price data and a single parameter that determines how much historical price data will be used in the calculation. Naturally, the more data is used, the more reliable the indicator is.

The main indicator of the RSI indicator for cryptocurrencies is divergence, that is, a discrepancy in price behavior and RSI readings. For example, when the price chart shows two upward highs, and the RSI cryptocurrency indicator shows two downward highs, then a trend reversal from an upward to a downward trend should be expected.

Formula RSI

RSI = 100 – 100 / (1 + RS). Where RS is average gain and average loss.

The RSI cryptocurrency indicator is not an independent analysis tool. Severe price fluctuations, long delays in the overbought or oversold zone – all this can negatively affect the accuracy of the forecast, therefore it should be used in connection with other technical analysis tools.

Conclusions