● Intermediate Technology

Understanding Technical Analysis in Crypto: A Beginner's Guide

10 minutes 21 days ago

Understand Technical Analysis

Technical analysis is the process of using past price data in an attempt to predict the future price movement. Finance analysts can assess market sentiments and then attempt to identify trading opportunities based on trends and price patterns on charts.

A Brief History of Technical Analysis

Charles Dow (1851–1902) was known as the father of technical analysis. In 1882, he and Edward Davis Jones founded a Wall Street news bureau, the Dow, Jones and Co.. A year later, they introduced the Customer's Afternoon Letter, a two-page summary of the day’s financial news. The news came with the Dow Jones Index—a compilation of 11 stocks, mostly railroad-based. By 1889, they decided to transform into a full-fledged financial newspaper, and The Wall Street Journal was born. Dow’s talented insights had since laid the foundation for Dow Theory, the cornerstone of today's modern technical analysis.

Dow Theory and the key principles of technical analysis

Although Dow Theory has been over a century old, it is still widely employed in today's markets. Dow Theory describes market trends and provides key principles to understand them. Let’s have a look at six key features of the Dow Theory:

  1. The market tells everything: If you want to know something, just look at the prices. All information relating to an asset, even the profit potential or competitive edge, is already reflected in its price. What you need is just to delve deep enough.
  2. The market boasts three trends: A market primarily has 2 trends, bearish and bullish. The secondary ones are usually against the foundational ones: they include corrections in bull markets and rallies in bear markets.
  3. Trends persist under 3 phases: For the bull market, this includes the accumulation, public participation, and excess stages. The bear market, on the other hand, involves distribution, public participation, and panic stages.
  4. Market indices work as a flow: If one index is suggesting a new primary downtrend, and another is signalling a primary uptrend, you might want to wait for clearer evidence. Yet if both signal the same upward or downward swing, traders can confirm that a new tendency may be emerging.
  5. Trends should match corresponding volumes: In a bull run, market volume should increase accordingly. Conversely, the market cap should decrease over time in a bearish trend. If the market volume decreases in a bull market, it could signify a bearish movement that could lead to a bear market.
  6. Trends persist until an apparent reversal occurs: Once a trend is established, technical analysts assume that it will continue until there is clear evidence of a reversal.

Technical analysis charts

Charts' purpose is to provide a visual representation of price action. There are various types of charts for multiple traders' uses.

  1. Line chart
    Line charts are the most basic type of chart used in technical analysis. They usually use only one data point: the closing price. To identify the trend, a series of closing prices over a period of time is plotted on a chart and joined to form a line.
    This type of chart also helps analysts to see patterns in price changes and assess a crypto’s performance. When several lines are laid out in a chart, it is far easier and especially useful for comparing an asset or sector’s performance against a benchmark.
  2. Bar charts
    Bar charts contain more information than line charts. The open, high, low, and close are used for every bar plotted on a chart. These charts are often called OHLC (open, high, low, close).
    An OHLC Chart uses the y-axis for price and the x-axis for time. Each period, for instance, a day, is represented by a symbol plotting four key values: the highest and lowest traded prices (shown by the length of a vertical line), and the opening and closing prices (marked by tick-marks on either side of this line). The symbols can be colored to indicate market sentiment: bullish with green (closing price higher than opening) or bearish with red (closing price lower than opening).
  3. Candlestick chart
    Candlestick charts were created in Japan in the 18th century by rice merchants. These charts then were brought to the West by Steven Nison in his book: “Japanese Candlestick Charting Techniques.” Similar to bar charts, candlesticks use open, high, low, and close, but with better visualisation. In fact, candlestick charts are one of the most popular charts used in the West and are available on all trading platforms. For short-term traders, there are charting services that will provide time frames from intervals of as little as one-minute charts and various intervals up to daily charts. For the longer-term trader, daily, weekly and monthly charts are useful.
    Each candlestick has two main parts: the body and the shadows, or "wicks." The body represents the difference between the opening and closing prices of a cryptocurrency within a specific time interval. The top wick indicates the highest price reached during that interval, while the bottom wick shows the lowest price.
    Candlesticks can be categorised as bearish (red-coloured) or bullish (green-coloured). A bullish candlestick has a closing price higher than its opening one. Conversely, a bearish candlestick indicates a higher opening price compared to its closing price. By analysing candlestick patterns on crypto charts, you can identify trends and might predict future market movements.

Key technical indicators

Technical indicators are pattern-based signals or mathematical calculations produced by or based on the price, market cap, or open interest of a security/commodity. These indicators are widely deployed by active traders as they are designed to study short-term price movements and predict future trends.

In these indicators’ introductions, you might find the phrase “support and resistance levels” several times. Basically, support levels occur when the demand for an asset rises to match the supply. This causes the price to stop falling and start to stabilise. If the support level is breached, prices usually continue to decline until a new support level is established. However, when a support level is broken, it often transforms into a new resistance level in the future.

Resistance levels, in contrast, are formed when supply matches demand. In an uptrend, prices continue to increase until they reach a level where demand no longer exceeds supply, and no more traders willing to sell at these levels.

Now, here are the most basic and commonly used technical indicators, especially in the crypto industry:

  1. Simple moving average
    Simple moving average is basically the average, mean, or the expected value (in statistics) of a token’s price over a specific period. This indicator takes a set of price points for a cryptocurrency and divides them by the number of data points to produce a single trend line.
    SMAs are often used to determine trend direction. If the indicator is moving up, the trend is bearish. Otherwise, it’s down. A 200-day SMA is a proxy for long-term trends, while 50-day SMAs are typical for intermediate trends.
  2. Exponential moving average
    Exponential Moving Average (EMA) is similar to the SMA as it also measures trend direction over a specific time period. However, EMA applies more weight to data which is more current and therefore it is more responsive to prices. The most popular EMAs for short-term averages are 12- and 26-day EMAs, and 50- and 200-day EMAs for long-term averages.
  3. Relative strength index
    The Relative Strength Index (RSI) measures the speed and change of price movements. The RSI oscillates between 0 and 100 and is represented by a line graph. A crypto asset is considered overbought when its RSI is greater than or equal to 70 and oversold when the figure goes under 30.
    An overbought signal indicates that a short-term rally has reached its peak and the asset is due to a price correction. Meanwhile, an oversold signal suggests that a short-term downtrend has reached exhaustion, and the asset is ready for a rally.
  4. Fibonacci Retracement
    Fibonacci Retracement is used to predict how far a market may retrace from its current trend. A retracement is a temporary dip or pullback in the market. When displaying Fibonacci Retracement, you first draw a trend line between two extreme points. Six parallel horizontal lines are then drawn crossing the trend line at the Fibonacci levels of 0.0%, 23.6%, 38.2%, 50%, 61.8%, and 100%.
    Traders usually use the Fibonacci retracement to confirm a perceived market move. It also helps in determining potential support and resistance levels, so that traders know when to open and close positions.
  5. Bollinger Bands
    Bollinger Bands are bands plotted above and below a cryptocurrency's SMA, based on standard deviation levels. The width of the band changes to reflect changes in the underlying crypto’s volatility.
    The lower the volatility, the closer the bands, and vice versa. They are mostly used to try and predict long-term price movements.
  6. On-Balance Volume
    The on-balance volume (OBV) indicator was developed by Joe Granville.
    It measures buying and selling pressure using volume rather than price. Granville surmised through his observations that volume precedes price. The OBV, therefore, is a running total of cumulative volume. When the volume on up days outpaces volume on down days, the OBV rises. When the volume on down days outpaces the volume on up days, the OBV falls.
  7. Moving Average Convergence Divergence
    Like RSI, The Moving Average Convergence/ Divergence (MACD) is a momentum oscillator. It is one of the most popular and well-known indicators developed in the late 1970s by Gerald Appel. This indicator is plotted with two lines:
    1. The MACD line, which is the difference between the 12-day exponential moving average (EMA) subtracted from the 26-day EMA
    2. The signal line, which is the 9-day EMA of the MACD
    3. The two lines fluctuate around a centre line, which is at zero. There is no upper and lower limit to the indicator.
    The most common use of the MACD is for signal line crossovers. The signal line trails the MACD line. When the MACD line turns up and crosses the signal line, that is bullish. When the MACD turns down and crosses the signal line, it is bearish.

Combining technical analysis with fundamental analysis

Fundamental analysis focuses on financial factors and economic indicators to determine an asset's intrinsic value, which is more suitable for long-term investment decisions.

Combining fundamental analysis with technical analysis results in a holistic trading strategy that allows a trader to benefit from the best of both worlds.

There are various ways to combine fundamental and technical analysis. One effective way is to use fundamental analysis to identify promising cryptocurrencies and assess whether they are overvalued or undervalued.

This aims to help mitigate risk by avoiding overpriced assets. After selecting the suitable cryptocurrencies, technical analysis can be used to determine the optimal entry point, manage the investment, and time the exit.

Limitations of technical analysis

  1. False signal
    Sometimes mathematical factors that contribute to a signal can cause flaws, and the market may move in a different direction.
  2. Open to interpretation
    There is no one rigid method of analysing charts, and two technical analysts may look at the same chart and see two different patterns, both of which can be justified.
  3. Ignores fundamentals
    Technical analysis ignores other important factors such as economic releases and outside market conditions.

Technical analysis tools for beginners

  1. Crypto rainbow chart

    The Rainbow Chart provides traders with a full spectrum of trends by visualising a range of simple moving averages (SMAs) of different lengths. The foundation of the Rainbow Chart is a 2-period simple moving average (MA). Recursive smoothing is then applied to this initial SMA, and the subsequent nine Rainbow Moving Averages are based on the previous SMA, each with a different length. The recursive smoothing allows the indicator to represent a comprehensive view of current trends in the market.

    The crypto Rainbow Chart is a technical analysis tool used in the cryptocurrency market to visualise historical price movements of a cryptocurrency and identify potential buying and selling opportunities. It’s important to keep in mind that this chart is not a predictive tool, but rather a historical reference of where a particular cryptocurrency might be in its market cycle.

    As an example, the Bitcoin Rainbow Chart is a visual representation of the market cycle for Bitcoin over time. It uses the colours of the rainbow to depict the stages of a typical market cycle, ranging from a bear-market bottom (blue) to euphoria (red).

    For beginners, understanding the Crypto Rainbow Chart involves recognising patterns of market sentiment and buyer behaviour.

  2. Crypto RSI

    The Relative Strength Index (RSI) is a popular momentum indicator used in technical analysis to measure the speed and change of recent price movements in a cryptocurrency with the same representation in traditional finance. RSI is displayed as an oscillator on a scale of 0 to 100, providing insights into whether an asset is overbought or oversold based on its recent price momentum over a specified period, usually 14 days.

    For beginners, the RSI serves as a valuable indicator to identify potential buying or selling opportunities in the market. When the RSI value exceeds 70, it suggests that the cryptocurrency may be overbought. Conversely, when the RSI falls below 30, it indicates that the cryptocurrency may be oversold.

    To use the Crypto RSI effectively, consider RSI signals in the context of broader market conditions and avoid making decisions solely based on RSI readings.

  3. Crypto Fear and Greed Index

    The Crypto Fear & Greed Index is a sentiment analysis tool that measures the emotions and attitudes of market participants towards the cryptocurrency market. It ranges from 0 to 100, with lower scores indicating fear and higher scores indicating greed. This index aggregates various data points like market volatility, trading volume, social media sentiment, and surveys to gauge market participant sentiment.

    For beginners, the Crypto Fear & Greed Index serves as a valuable tool for understanding the prevailing market sentiment and can be used to support decision-making. For instance, during a Fear Index era, valuable assets might be undervalued due to panic selling. On the other hand, during the Greed Index era, investments might be overvalued due to over-optimistic market sentiment.

    To use the Crypto Fear & Greed Index effectively, beginners should monitor it regularly to gauge the overall sentiment of the market. However, remember that sentiment analysis is just one aspect of making trading decisions.

FAQs

What are stop loss and take profit orders?

A stop loss (SL) order is an order placed by a trader to automatically close an open position (trade) when a predetermined price is reached to avoid potential or further losses. A take-profit (TP) order, on the other hand, automatically closes a trade at a predetermined price to lock in profits.

What do volume and liquidity mean?

The total number of cryptocurrency units traded over a specific period is referred to as the "volume" of a trade. The term "liquidity" refers to how quickly or easily it is to buy or sell a cryptocurrency on an exchange for its current market price.

What's the main difference between fundamental and technical analysis?

Fundamental analysis assesses cryptocurrency holdings by calculating their intrinsic value.

Technical analysis, on the other hand, ignores all fundamentals, assuming that they have already been priced in. Instead, it utilises charts to identify patterns and trends that may forecast future price movements.

What are some common technical indicators used in technical analysis?

Some common technical indicators used in technical analysis include moving averages, Relative Strength Index (RSI), Fibonacci retracements, Bollinger Bands, and chart patterns such as head and shoulders and triangles.

Is technical analysis suitable for all types of cryptocurrencies?

Technical analysis can be used for most cryptocurrencies, but it may not always be effective for less liquid cryptocurrencies with low trading volumes.

Additionally, it is important to consider the unique characteristics and market conditions of each individual cryptocurrency when using technical analysis.

Can technical analysis predict the exact future price of a cryptocurrency?

No, technical analysis cannot predict the exact future price of a cryptocurrency. It is a tool used to identify potential trends and price movements based on historical price patterns and market trends.

However, the market is unpredictable, and there are always factors that may impact price movements outside of technical analysis.

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