What is Technical Analysis?
Hailed by some as a highly effective tool set for interpreting financial markets and making informed decisions about price behavior, technical analysis can be understood as a kind of data science. Depending on who you ask, it can also be seen as something closer to a form of divination, like how the ancient Romans used to “tell the future” by studying the flight patterns of birds. Particularly when it comes to cryptocurrencies, there is an ongoing debate concerning whether or not traditional technical analysis strategies actually help to interpret the charts.
In the world of traditional finance, there are two methods that are typically used to predict the value of an asset: technical analysis and fundamental analysis. Fundamental analysis works by looking at a particular asset’s inherent value, or what it should be worth, in relation to the properties of the asset and overall market conditions. Fundamental analysis is more commonly associated with long term trading. Technical analysis involves looking at charts and identifying patterns behavior that can be used to predict price movement. Short-term traders, like day traders, often rely more on technical analysis.
The high volatility makes Bitcoin a popular asset for short-term traders. There is a potential to profit from price fluctuations that are generally much more extreme than in traditional financial markets, such as the stock market. Since short term traders tend to rely heavily on technical analysis, it is worth looking at some of the popular indicators that are applied to Bitcoin.
One of the most common indicators used in technical analysis is the use of moving averages. The simplest form of moving average is aptly called the “simple moving average”, which looks as the average price of a particular asset over a period of time. On charts, the simple moving average will often be abbreviated as SMA. For example, traders might look at the average price of Bitcoin over a period of 12 days, or SMA 12.
Another kind of moving average is an “exponential moving average”, or EMA. Exponential moving averages put more weight (exponentially more weight, to be precise) on recent price values as opposed to older ones when determining the average price. The 12 and 26 day exponential moving averages are some of the most popular short-term averages used by traders.
In fact, it is from these two EMAs that another indicator, known as MACD, is determined. MACD stands for “moving average convergence divergence”, which sounds complicated but is actually pretty straightforward. The 26 day EMA is subtracted from the 12 day EMA to get the MACD. The 9 day EMA of the MACD is then plotted on top of the MACD and used as a “signal line”. When crossovers happen between the two values, these can indicate changing trends and good times to sell or buy.
RSI: Relative Strength Index
RSI is a technical analysis metric for measuring momentum, and it is often used as a way to determine if an asset is overbought or oversold. Relative strength (the RS) is measured on an index (the I) of 0-100. RS is calculated by taking the average gain during up period divided by the average loss during down periods over a specified time frame, typically 14 days. RSI below 30 is regularly cited as a tell-tale sign of an oversold market, implying the price should move up in the near future, “not only with Bitcoin but also with S&P 500, NASDAQ Composite Index and Dow Jones Index to name a few. Surprisingly enough, even the figure of RSI level of 30 applies to all of these. That means, whenever RSI level comes close to 30, we can expect a trend reversal, even if that reversal is short-lived.”
Support and Resistance Levels
Support and resistance are important indicators related to, basically, how much people are willing to pay for a particular asset. As Coindesk explains, “By identifying these levels, bitcoin traders can help get a better sense of the supply and demand surrounding the digital currency.” A support level is generally the price at which a large number of people are willing to buy, implying that the market largely believes the asset or security is “undervalued”. Conversely, a resistance level is when a large number of people are willing to sell, fearing that the asset may be overvalued.
Bitcoin’s price often fluctuates within a range between a support and resistance line. If the price surpasses a resistance line, it can be a sign of a “breakout”, meaning that market demand for the underlying asset has increased sufficiently to drive the price up. In this case, a former resistance line can become a new support line. Or, if the price drops below a level of support, it can be an indicator that demand has fallen, and the price may continue to drop down until it finds a new level of support.
Does Technical Analysis Really Work?
One fairly in-depth study looking at technical analysis in relation to cryptocurrency concluded, “Generally used technical indicator events do NOT appear to be good predictors of above average, or negative, returns for cryptocurrencies when utilizing daily prices and when used alone.” That might sound like a pretty solid “no”, but there is an important caveat in the “when used alone” part. In general, relying exclusively on technical analysis is a strategy that not even the pro traders typically recommend, but rather supplementing a broader trading strategy with technical analysis.
Because Bitcoin markets are highly volatile and do not follow the same regulatory guidelines as traditional finance, most experienced traders suggest looking at fundamentals, such as news, project specifications, market sentiment, and other factors in addition to using technical analysis techniques to study the charts. As one article put it, “the recommendation is to mix together the technical analysis and the fundamentals analysis to make wise investment decisions.”