This is part two of “Crypto Markets - Improving Trading Beyond Technical Analysis.” Part one can be found here.
What is Technical Analysis (TA)?
Technical analysis is a topic that no matter in which market it is applied (stocks, forex, crypto, etc), there are always polarized views – the trading front lines are filled with passionate haters of TA, as well as traders who swear by its use and use it to make a living. There will always be people that say it doesn’t work.
A commonly accepted view is that regardless of its validity, if enough people use TA to make investment decisions, then at a minimum it often becomes a “self-fulfilling prophecy” and therefore holds some amount of predictive power.
The key foundational principals of technical analysis are based on “The Dow Theory.” There are already many articles that go into a lot of detail, so here are the key points:
- An asset’s (crypto in this case) current market price reflects all existing information, including the knowledge and expectations of all market participants. All existing, prior, and upcoming details have already been reflected in current asset prices. As a result, chartists/technicians (traders using TA) seek to interpret what the price is saying about market sentiment to make educated predictions about future pricing.
- Prices movements are not completely random. Instead, they frequently follow trends, which can be either short or longer term. Once an asset’s price forms a trend, it is more likely to follow that trend than move contrary to this trend. Through technical analysis, technicians seek to identify trends and profit from them.
- ‘What’ is more important than ‘Why’. There are innumerable factors could have caused a asset’s market price to move in a certain way, technicians take a more direct approach by analyzing supply and demand.
- History has a tendency to repeat itself and it is possible to predict market psychology. Traders often respond the same way when provided with similar stimuli. A good example of this in cryptocurrencies would be bullish price movements in response to news/events suggesting rising adoption or greater visibility.
As you can probably guess, all of these points are passionately disputed, and the dispute gets especially heated in such non-efficient markets like the cryptocurrency markets.
Types of Common Technical Analysis Indicators
There are myriad technical indicators that exist. Every trader has their own favorites, each swearing by their use in one way or another. Below are some examples of TA indicators.
Trend Lines
At its core, trend lines are simple and are just lines that connect the highest-high points and the lowest-low points to allow a trader to identify the channel in which a security is trading. These trends can be upward (bullish), downward (bearish) or sideways. Trends can continue for varying lengths of time as well – short, intermediate, or long. The basics of an upward trend will be a series of higher highs and higher lows.
Resistance and support levels
As there are trend lines, there are also horizontal lines that express levels of support and resistance. A support level exists when an asset’s price is met by enough demand (buyers of the security) to stop the decline of the asset price. This will act as a ‘floor’ under which the security’s price will not fall. A resistance level is the opposite – a price level where demand is scarce and sellers will patiently wait with their orders, forming a large supply zone. When an asset’s price reaches a resistance level, sellers outnumber buyers and this price will act as a ‘ceiling’; the asset’s price will struggle to extend above this level of resistance.
Typically, if a security’s prices breaks through a price level that previously served as resistance, this price frequently ends up serving as a support level. Alternatively, the opposite could happen, with the security’s price falling below support, resulting in this level becoming a new resistance level.
A breakout is typically an indicator of strengthening of an existing trend; see the below example.
The above LTC/EUR shows a clear uptrend, as well as support & resistance lines.
Moving averages
A key concept for technical analysis is the use of moving averages. This allows traders to easily identify trends by smoothing out a security’s price fluctuations so market participants can get a better sense of where the price has been going. A moving average is based on the average price of the coin over a certain period of time. For example, a moving average of a given day will be calculated according to the price of the coin for each of the 20 trading days prior to that day. Connecting all moving averages forms a line.
The most common moving averages are Simple Moving Average (SMA), which is determined by calculating a security’s average price over a specific time period (e.g. 5 days), and Exponential Moving Average (EMA), a moving average that gives more weight in its calculation to the price values of the last few days than the previous days.
Reading and interpreting moving averages is somewhat of an art (as with all readings of technical analysis), but generally, if the shorter period moving average (e.g. 10 day moving average) crosses above a longer period moving average (e.g. 30 day moving average), it might tell us that a positive trend is likely coming (bullish), and vice versa.
Trading Volume
Trading volume always plays a very important role in identifying trends. Significant trends are accompanied by a high trading volume, while weak trends are accompanied by a low trading volume. When a security goes down it is advisable to check the volume which accompanied the decline. A long-term trend of healthy growth is accompanied by a high volume of increases and a low volume of declines. It is also important to see that volume is rising over time. If the volume is decreasing during price increases, the upward price trend is likely to come to an end, and vice versa during a downtrend. Volume also indicates the liquidity of a given asset; the importance of liquidity is often forgotten until it dries up, and then the lack of liquidity is punishing.
A note on using TA...
As discussed in part one, there are many different Technical analysis indicators: Moving Averages, Moving average convergence divergence (MACD), Relative Strength Index (RSI), Commodity Channel Index (CCI), etc. Everyone has their favorites and each indicator will do its job in terms of calculations. All of these indicators are taking price and volume data and using this to attempt to predict future price movements. However, there is absolutely no "holy grail" single indicator or signal. Profiting using TA in trading is less about how individual trading indicators work, and rather more about how these indicators are used as part of a trading plan.
Why use Technical Analysis?
Although the recent increase of the cryptocurrencies’ market cap has been substantial, the market cap is still quite low compared to those of Forex or Equities. I believe that that this trend will not only continue, but will increase. With a such a volatile/smaller market, such as Crypto, non-institutional traders can have a greater impact on the market.
With the increased interest in the cryptocurrency markets comes an influx of many novice traders. These traders, often new to trading in general, flock to YouTube ‘experts’ on how to profit by trading. These searches often end up with learning the basics of TA.
New traders, with an combined rather large amount of capital enter the market trading on basic TA. This creates the self-fulfilling prophecy - breakouts occur when they should occur and support and resistance levels perform exactly as one would expect. This has allowed traders with basic TA skills to successfully day trade, and quite easily too.
In crypto, it does seem that BASIC TA seems to be very powerful, more so than more advanced indicators. I, like many others, believe this is due to the large number of traders who had found success trading using the basics and never moved on to more advanced indicators. This allows for traders applying basic TA to outperform.
Please stay tuned for Crypto Markets - Improving Trading Beyond Technical Analysis (Part 3), where I'll go into some issues with using Technical Analysis and what you can do to fix it.
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