In this volatile cryptocurrency market, investors and traders should take their vital trading decisions based on the two available methods of analysis. One is a financial analysis that involves analyzing financial statements like the balance sheet, income statements, cash flow statements, and shareholder’s equity statement. And the second one is the most important for cryptocurrencies is technical analysis. This involves an analysis of the price trends based on market sentiments and predicting where the prices will be in the future.
What is Technical Analysis?
In simple language, technical analysis collects the historic price and volume data and then analyzes them to ascertain the profitable trades. Technical analysts use charting tools to analyze the past data trends and place them side by side with real-time data. The experienced analysts and traders of the stock, currency, forex, or commodity markets also use similar patterns of technical analysis while predicting the future prices of the assets.
The Basis of Technical Analysis
The Dow Theory provides a framework for technical analysis for the stock market and this is used for technical analysis of cryptocurrencies. The basic idea of this theory is, that prices in the market include everything. For cryptocurrencies, it may include past, present, and future demands, trader’s expectations, regulations of the exchange, knowledge of the crypto, etc. Another basic principle followed by the technical analysts to identify the trends in Bitcoins and other cryptos are that history repeats itself when it comes to price trends.
Another idea followed is that price movements are never random, these follow a trend. The trends may be short-term or long-term for any cryptocurrency and eventually, you will see a reverse trend also. Technical analysis is concerned about what is happening and not why it is happening.
When a cryptocurrency trader is doing technical analysis, the focus is on supply and demand instead of the other variables that influence the price fluctuation. After carrying out the technical analysis of the cryptocurrency, the trader gets to know the market sentiment. Then, based on market psychology, the trader can isolate the price trends and invest accordingly.
Types of Trend
The first element of technical analysis is the trend line that shows the direction in which the cryptocurrency moves. Primarily there are three types of trends, viz. Uptrend, sideways trend, and downtrend.
- Uptrend: As evident from its name, the trend in the price of assets goes higher and makes higher highs and higher lows.
- Sidetrend: This is a complicated trend line. It shows that the prices of the cryptocurrency have not moved much and fluctuates between a trading range. Between this range, it makes highs and lows.
- Downtrend: In a downtrend, the representing line shows the cryptocurrency prices when it is going down making lower lows and lower highs.
The terms bullish and bearish are also used for an uptrend and a downtrend. There are softwares drawing the trendlines, but as a trader, you should place your own trendline.
Resistance and Support
The price movements in your asset are not linear; it may face resistance while going up and support while coming down.
Resistance: In this level, the supply is high with little demand. The buyers in the market feel that the cryptocurrency is being traded at a higher price and resist from buying. So, at this resistance level, the supply of the crypto is more and this pushes the price down.
Support: Many traders want to buy the asset or the cryptocurrency in huge volume in the support level. The demand is high as the traders feel that the prices are low. In such a situation, the decline in prices is halted and the prices start moving upwards.
Following the technical analysis, the support is used as the entry point for an investor and the resistance is used as the exit point. When the trends are very strong, then the prices may move further through the resistance and support too. Sometimes the trends may not show the correct market movements and there may be breakouts, so traders should analyse multiple data to come at the trends.
Advanced Technical Analysis Tools
The most popular advanced technical analysis tool used by analysts and traders in the cryptocurrency market is the candlestick chart or Open-High-Low-Close Chart (OHLC Chart). These charts are plotted using the open, close, high, and low prices of the cryptocurrency and resemble a candle. The shape is like a rectangle, with a line similar to a candle’s wick coming out of the top and bottom. The candlestick and the wick’s sizes give the trader vital information about the volatility of the market and the market trend. The wicks show lowest and highest prices of the cryptocurrency and show how volatile the market is.
There are two types of OHLC Charts, viz. Bullish Candle and Bearish Candle.
- Bullish Candle: Here the opening price is at the bottom and the closing price at the top. This chart is green or white in color and shows the positive or bullish movement of price.
- Bearish Candle: Just opposite to the Bullish Candle, the closing price is at the bottom and the opening at the top indicates that the prices fell during the trading day. This chart is red or black in color and shows the negative market trend or bearish price movement.
Gaining Information from the Candlestick Charts
The candlestick charts are used to make future trade predictions. Like, if the wick is long, the market is volatile which means there is a higher chance of significant losses or gains in the applicable period. A longer wick also means that the market may correct the next day.
When the wick is short, it is likely that the highest price was significant for that crypto and for that day. Also, it indicates a potential change within a short period.
If the top wick is longer, it indicates that the crypto was expensive at some point and then the traders booked profit and sold it. This also indicates that in near future the prices will go down or become bearish.
If the wick is short on the bottom, this indicates that traders are selling the crypto. This will result in more supply and the crypto prices will drop. On the other side, a longer wick at the bottom will indicate that the prices are already low and won’t dip further. So, you can predict that traders will buy more at this price and then the trend becomes an upward one.
Simple Moving Average
This is an average of the closing prices of the cryptocurrency over a chosen period of time. This is a crucial part of technical analysis that helps you to find out the trends. The moving average is typically calculated for the past 20 days trading prices of the cryptocurrency. A trader can connect the different moving averages and plot a line that provides guidance on the market movements and prices.
Understanding Relative Strength Index (RSI)
All the cryptocurrency charting methods include RSI or Relative Strength Index. There is a formula to calculate the RSI which is 100 – 100/(1-RS), where RS is the ratio that separates the average number of days when the crypto was down and when it was down. The RSI value can be between 1 and 100 and an RSI close to 30 or less indicates that the crypto is available at a lower price than it should be i.e. undervalues and the prices may rise soon. RSI that approaches 70 indicates that the crypto is in the overbought zone and the prices may drop at any time.
These types of bands represent the envelope (or graphical band) and follow the simple moving average as it passes through the middle. The volatility in the market is denoted by the width of the band.
Volatility or fluctuations in the market refers to the rate of change in prices of an asset. If the value of the asset is prone to changes in price, the asset has what is called higher volatility, otherwise, it’s called low volatility.
If the prices deviate from the average, it’s known to have mean reversion. It’s similar to a spring that returns to its original equilibrium position and as we stretch it more, it returns with an even greater force.
Moving Average Convergence Divergence (MACD)
The MACD or Moving Average Convergence Divergence is a market analytical tool that indicates at two moving averages, i.e., long-run moving average, and short-run moving average. These two indicators are looked at in a combination to identify the trend in the market. It can also tell us if there has been a change in momentum.
The MACD chart is represented using two color lines, blue, and red. The momentum and trend is bullish if the blue line is above the red. As you can figure out, the market trend and momentum are bearish if the red line is above the blue line. If there’s a divergence of the red line and blue line, it’s indicative that the current trend is strengthening. A convergence of lines shows a weakening of the trend. A change in trend and momentum is denoted by the crossing of the lines.
Understanding Trading Volumes
The volumes of the cryptocurrency traded is also an important element of technical analysis. High trading volumes shows that the trend is significant for your investment considerations and a low trading volume shows that the trend is weak and you may refrain from investing for the time being.
Understanding Market Caps
The market cap of the specific cryptocurrency indicates the stability of the coin. To calculate the market cap you have to multiply the price of one coin by the total coins circulating in the market. A larger market cap indicates that the crypto is stable and the prices may not fall very fast.
How Does Technical Analysis Work?
The charts representing volumes and prices denotes all the decisions taken by investors previously, i.e., buying or selling. This information affects the decision of potential investors in two ways-
- Reflexive: Some crypto traders look at price and volume charts to identify common trends in the crypto market. If an adequate number of traders follow a similar strategy, it’s expected that the charts will have the expected outcome. The trend will be carried forward by future participants.
- Psychological: Your past in the crypto market shapes your approach in future situations. For instance, most crypto traders pay more heed towards the price of the asset at which they bought it, and if it falls, they would prefer to sell when the asset price crosses the break-even point.
Can News Affect the Prices of Assets?
Media is one of the most effective ways of influencing and persuading the public. News plays a significant role in changing investors’ decisions. Breaking news regarding any asset can either cause panic in the market and lead to a selloff. It can also trigger an upward rally for the asset where most investors buy that asset in large volumes. The cryptocurrency market has always been affected by news in rather a big way. For instance, in 2017, when the financial authorities in China banned ICOs, the price of Bitcoin dropped. The COVID-19 situation also resulted in panic in the crypto market as Bitcoin reached its lowest point in 8 years.