Trading cryptocurrency? Here is what you need to know about technical analysis
30 min Beginners Beginners
Probably you have heard of moving averages, support and resistance lines or Fibonacci retracements, but don’t know what is it all about. If the above terms sound like double Dutch to you, then it’s time to learn what is Technical Analysis, which are its main tools and how you can you take advantage of them to make money in cryptocurrencies.
Simply put, Technical Analysis focuses on the study of the effect that factors, such as fundamentals or psychology, exert on prices, which may affect to the supply/demand equation in order to predict the future trend of prices. By using different analytical techniques, the technical analyst tries to find a solution to the problem of choosing the right moment to buy or sell a cryptocurrency (or any other asset).
The main idea behind Technical Analysis is that assets prices move in trends, which are the result of the changing attitude of traders and investors towards the socio-economic and political environment, as well as their own perception of the market. Therefore, the most important thing for the technical analyst will be to identify the trend in its early stages and maintain the investment until there are signs of change in its direction. Behind all this process, there is the assumption that human nature is constant over time and reacts equally to similar situations.
The Foundations of Technical Analysis
There are three premises on which the technical analysis approach is based:
1. Market action discounts everything
Technical Analysis assumes that, in addition to the fundamental criteria that may partly explain the variations of the supply/demand equation, there are many other factors (economic, political, social, psychological, etc.) that are constantly influencing prices. Prices not only reflect the different assessment that different analysts can establish but also reflect the hopes, fears, assumptions and criteria, whether rational or irrational, of thousands of potential buyers and sellers. This set of factors, on which a statistic cannot be established, are synthesized, weighed, and finally expressed in a final number: the price at which a transaction is closed. In short, Technical Analysis takes as its starting point the assumption that the establishment of a price includes in itself all the fundamental information available and, in addition, many other aspects of equal or greater importance.
2. Prices move in trends
The concept of a trend is one of the basic pillars of Technical Analysis theory. Starting from the most elementary definition of a trend as the direction in which prices move, the technical analyst assumes that markets move in trends, and that these "tend" to continue until changes are produced that can induce imbalances in the supply/demand equation, being able to detect those changes analyzing the market action. The adequate identification of the trend from its early stages with the intention of operating following its direction and the early detection of its exhaustion to reverse or close the position, constitute in sum the final objectives pursued by the technical analyst.
3. History repeats itself
This apparently simple statement, and even questionable in certain aspects, takes on a special dimension when it is verified that certain patterns of behavior that have been cataloged in the past, continue to repeat nowadays in financial markets. This repetitiveness, whose origin is none other than the very nature of human psychology, makes it possible to establish that the future movements of the market will be very similar to those that occurred in the past and that, consequently, the implications derived in the past from the different chart patterns are absolutely applicable to similar formations. In this way, given that the cryptocurrency charts are a true reflection of the market action, that is, of the activity of the group of investors participating in it, it is easy to understand that if their psychology remains basically unaltered, the chart patterns that shape the evolution of prices will continue to repeat themselves and maintain their validity over the years.
Price action, as a result of human decision making, can be thus considered as being purposeful. Although some people believe that price movement is completely random and unpredictable, technical analysts are always prone to identify and quantify those behavior patterns by examining past markets. While markets are unpredictable in essence, market participants are typically considered to adhere to certain habits, which are rarely broken. As a trader, your goal is to make use of this information in order to gain a slight advantage over the eventual unpredictability of the market.
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Predicting the 1929 crash
William P. Hamilton is considered one of the founders of technical analysis, using oceanic metaphors such as tides, waves, and splashes. He called bull and bear markets with a high level of accuracy.
On October 21st, 1929, he called the crash in stocks that came three days later. Unfortunately, he did not live to enjoy the fame and died in November.
The Drawbacks of Technical Analysis
Despite the fact it may represent a true edge for the trader, the technical analysis presents some disadvantages. Those who oppose technical analysis point out several problems related to the application of its methods:
1. The failure to know the underlying fundamentals.
A common argument is that technical analysis is aimed at predicting a certain outcome for a chart pattern, ignoring the reasons for the movements which are due to fundamental factors.
2. The self-fulfilling prophecy.
Technical Analysis could be considered a case of self-fulfilling prophecy, referring to the fact that the more people approaching markets with the same analytical methods, the more likely the expected move in price occurs. This is a common argument that points out the lack of a proven thesis. The fact that traders operate with different time horizons, different expectations and risk profiles makes it difficult to find a common approach to the self-fulfilling prophecy.
3. The uniqueness of the pattern occurrences.
Another legitimate argument in favor of the unreliability of technical analysis is based on the true observation that past price action upon which technical methods are based does not often repeat exactly the same way. This can lead to inconsistencies in the analysis and to inconsistency in the methods. In other words: past market action might not be as useful as a predictor.
Regardless of whether technical analysis works or not, what is definitely true is that traders will never be 100% right when using any kind of strategy in the market (it couldn’t be otherwise). However, using Technical Analysis paves the way to rule-based trading, which will help us to develop our personal trading style.
More often than not, using technical analysis can help build strategies with a positive expectancy. You won't win every trade but by trading systematically only when the odds are in your favor, the true edge of technical analysis will reveal itself.
Of course, the analysis doesn't make the whole trading plan. A proper money management and a trained attitude to stick to the rules are elements which offer additional edges to include in the trading plan.
In the next chapters, we will review some of the classical patterns as well as indicators and oscillators, learning how to embed them in a trading strategy.