Why Is Technical Analysis Important to Trade Bitcoin?
In technical analysis, the main goal is to help traders analyze the past performance of a trading instrument and predict what may happen in the future. A trader who uses technical analysis, aka technical trader, will evaluate the price fluctuation, volume data, price levels, and trading sessions to hedge investment risks. While technical analysts generally observe and interpret the price movements and patterns formed in the past to formulate trading ideas to forecast the next price trend.
TA is a common analysis used to assess stocks and other assets in traditional financial markets. But it is also an essential component to trading digital assets in the crypto market. In fact, technical analysis is quick and easy to understand, but it requires discipline and dedication to master it.
In the following section, we’ll look at everything a trader should know about analyzing cryptocurrency using technical analysis.
What is Technical Analysis (TA)?
Technical analysis is used to forecast the future price movement of an asset by analyzing its past price action and volume data — TA focuses on assessing the historical trading activities and chart patterns to identify trends and trading opportunities.
Technical and fundamental analysis considers multiple factors regarding price. In fundamental analysis, the most effective price direction comes from economic events, fundamental releases, and geopolitical events.
On the other hand, TA focuses solely on past events, price action, and trading activity. The best part of technical analysis is that it doesn’t require you to be a finance graduate to understand it. Anyone with an understanding of the market forces of supply and demand and the core concept of technical indicators can easily spot favorable trading opportunities.
The foundations of technical analysis appeared in 17th-century Amsterdam and 18th-century Japan. However, modern technical analysis is a result of the work of Charles Dow, a financial journalist and the founder of The Wall Street Journal.
Dow was the first person to observe that a trading asset often moves within a trend and remains in a range most of the time. Later on, his work gave birth to Dow Theory, which gave further impetus to technical analysis.
How Does Technical Analysis Work?
Technical analysis is a process used to study past price actions and anticipate future price movements. The core concept of price action is that the price in a trading instrument doesn’t move randomly. Instead, there’s a story behind the price movement, and technical analysts can read the price history like a book and predict what may happen next.
Price movement in the cryptocurrency market happens with the change in supply and demand. When supply exceeds demand, a price will move down, and when demand exceeds supply, the price will rise.
But the main question is when and how the price will move.
Technical analysts’ primary duty is to calculate the overall market context and find the exact point from which the price has a higher possibility of making a move.
TA is the most reliable and effective way to anticipate price movement. However, it requires several tools and elements. For example, besides using candlestick charts, volume and liquidity traders often use various charting tools known as indicators.
Let’s look at the core elements of technical analysis in the cryptocurrency market.
Price action uses price fluctuation and volume charts, allowing traders to predict what may happen in the future.
There are no specific tools for price action traders. However, traders can make profits by analyzing the price chart, while other traders include price levels, patterns, and indicators to observe the price action.
Let’s have a look at how price action pattern works in financial trading:Sample of head and shoulder candlestick pattern
In the above image, we can see an example of a Head and Shoulders pattern, a potential price action reversal pattern in which any breakout from the neckline indicates a significant price change.
Some other examples of price patterns are as follows:Price action patterns
Candlesticks are the most effective tool used in technical analysis. Japanese candlesticks (similar to OHLC charts) are used by most technical analysts in the world. The core idea of using candlesticks is to observe the current candle formation and, based on a single candlestick or group of candlesticks, anticipate what may happen next.
Candlesticks usually show reversal and continuation price setups. Using this tool as an indicator, any reliable candlestick reversal from a support level points out a good buying opportunity, as shown in the image below:
Now, we’ll move to how a continuation price format appears with the candlestick formation:Sample of bullish engulfing pattern during a crypto bullish trend.
Overall, technical analysts should know how to analyze cryptocurrency using candlesticks from an appropriate support and resistance level.
Trend and Momentum
Price action covers the nature of trends. During an impulsive trend, the price makes new highs or lows, with aggressive buying or selling pressure. On the other hand, in a corrective trend, price barely makes new highs or lows.
Let’s see an example of impulse and correction from a Bitcoin chart:
In mid-May 2021, Bitcoin’s price was in a correction. After testing the $60,000 resistance level, an impulse trend led to an aggressive move from $60,000 to $30,000 in just 12 days.
These aggressive movements indicate the price’s momentum. When the impulsive movement is in the seller’s direction, the market momentum is bearish. In that case, traders should take only sell trades. On the other hand, buying and holding a cryptocurrency is profitable when the market momentum is bullish.
In the beginning phases of technical analysis, there was no electronic charting system. Traders used to write prices using paper and pen.
Now, technology makes trading more effective, especially in the cryptocurrency market. Traders can use technical indicators to see the possible price movement in a more predictive way.
Technical indicators show the current position of price based on specific metrics. However, to obtain a reliable outcome from technical analysis, traders should know how to use several important indicators.
Top Technical Indicators
In technical analysis, there is no way to ignore indicators. Traders should know how to use the basic indicators in the following section.
Relative Strength Index (RSI)
RSI is a momentum indicator that plots results on a scale of 1–100. It shows the overbought and oversold conditions of assets. If the RSI indicator moves below 30, it indicates a bearish pressure in the price.
Moreover, when the RSI indicator moves to the oversold zone, i.e., above 70, it means an asset is overbought and may experience price bounces. Because RSI is a momentum indicator, the price can stay overbought or oversold for a long time. Therefore, as with most other technical indicators, RSI signals are more efficient and reliable with long-term trends and when combined with additional indicators.RSI indicator showing the overbought and oversold levels.
The above image shows how the price changes its direction from the overbought and oversold areas.
Moving Average (MA)
Moving average shows the average price of a crypto trading asset for a particular time frame. A daily MA of 20 represents the average price of the last 20 days’ price movements. The core idea of using a moving average is to anticipate price movement by observing the price’s behavior.
For long-term price analysis, simple moving average (SMA) works well, while for short-term price analysis, exponential moving average (EMA) is effective. The best part of using EMA is that it places more weight and significance on the most recent data points. It identifies bullish or bearish signals based on crossovers and divergences from the historical average.
Based on the above picture, the long-term trend is bearish as the price remains below the 200 SMA. Therefore, traders can find sell signals using the 20 EMA toward the selling direction.
Moving average convergence divergence (MACD) is another commonly used momentum indicator. It shows the connection between two key moving averages. When a MACD histogram moves above zero, it indicates a bullish market. Likewise, if the reading crosses below the signal line, it shows a bearish price movement for an asset.
Therefore, the primary idea is to determine the upcoming price direction by observing the location of the histogram. Another approach is to match highs and lows with the price, thereby finding divergence. When divergence occurs, it’s a sign the price is likely to change its direction.MACD histogram
In the above image, we can see Bitcoin’s price moving down to 35,000 and forming a regular divergence with the MACD. Later on, the price moves higher, followed by higher highs in the MACD histogram.
Bollinger Bands are a technical indicator used widely in various markets, including stocks, futures, and currencies. In the 1980s, John Bollinger developed this tool that grants exceptional insights into the relationship between price and volatility. Additionally, you can use Bollinger Bands to identify both overbought and oversold levels. This capability can help you both as a trend-following instrument and for finding breakouts.
How do we calculate Bollinger Bands in the daily time frame?
To assess the SMA of security, we commonly utilize a 20-day SMA. This is the initial phase in calculating Bollinger bands. As the first data point, a 20-day SMA averages the closing prices for the initial 20 days. The following data point would drop the maximum price, add the price on day 21, and take the average. The standard deviation of the security’s price will be attainable after that.The breakdown of the mechanism of bollinger bands in a trading chart.
The upper and lower bands work as dynamic support and resistance to the price, while the middle point shows the average price of these lines. Thus, any rejection from the upper and lower bands can be an entry point for a trade, and the middle point is the first take-profit level.
Pivots and Fibonacci
In trading, a pivot point is an indicator that uses the core concept of supply and demand in regard to price. We all know that price fluctuates with changes in supply and demand, but there is a price level where supply and demand remain almost the same. This level is known as the equilibrium point.
In financial trading, a pivot point represents the point of equilibrium. When a price approaches this level, it may work as a support or as resistance. Moreover, the pivot point includes multiple support and resistance levels below and above the equilibrium point, which can also serve as price shift points.
Any lines above the pivot point are resistant in the above image, and those below the pivot point are supported. The basic approach is to find a reliable candlestick formation from pivot points and to consider the support of, and resistance to, take-profit levels.
Let’s move on to Fibonacci.
Fibonacci numbers are an important mathematical phenomenon found everywhere in the natural world. In financial trading, Fibonacci retracement helps traders identify the correction and extension amount of a price. For example, after an impulsive trend, traders can expect 38.2%, 50%, or 61.8% Fibonacci correction before making another impulsive move.
Additionally, the Fibonacci extension tool helps predict how long a price may go after a correction. It uses significant values like 161.8% or 261.8% to indicate a potential take-profit or price reversal point.Fibonacci Retracement and Extension illustration.
The above image indicates 38.2%, 50%, and 61.8% retracement in the Bitcoin chart, with its price ultimately dropping to the 361.8% extension level.
The Flaws of Technical Analysis
On April 25, 2021, Bitcoin’s price rejected the $49,000 support level with a bullish daily close. Later on, the price made a new high on May 12 with the price of $57,732, creating hope for a new all-time high above $60,000. At that time, most of the technical indicators showed buy signals on the daily chart. However, strong fundamental news regarding a crypto payment ban came from China, which crashed the market from $59,507 to $30,065 in mid-May.
The above scenario is a perfect example of one in which technical analysis has failed due to the unanticipated rules and regulations imposed on the crypto market. Here traders are using multiple indicators and trading tools to anticipate the price movement. However, as always, there is no guarantee that the price will follow the indicated direction. Plus, TA can be inaccurate due to personal bias and subjectivity.
In technical analysis, the biggest drawback is that any fundamental event, or perhaps geopolitical news, can invalidate all technical outlooks. The ultimate challenge is to take maximal benefit from trade with minimal risk.
The best approach is to study a cryptocurrency’s background and obtain reliable information about it. Identify recent news and developments, and match the technical analysis with the direction of fundamentals.
Another drawback of technical analysis is that it depends on past price actions. Technical analysis usually fails given if the market does not present a clear pattern or trend. To add on, it is often difficult to find previous data for new coins. Even if previous data is found, it might not be reliable due to volatility.
Despite dealing with empirical data, technical analysis can also fail during periods when markets don’t present a clear pattern or trend.
Fundamental Analysis vs. Technical Analysis
Fundamental analysts emphasize qualitative factors, whereas technical analysts focus on historical price charts to assess an asset’s performance. While both generate an efficient market hypothesis, the technical trading strategies still rely on how a trader perceives the information from these analyses.
The fundamental analysis (FA) considers the macro conditions of the assets to predict the future price movement. For example, the high consumer adoption in decentralized finance (DeFi) or the strong support from the community may be the key drivers for DeFi’s token price surge. Thus, taking these factors into considerations help traders to predict future movements of an asset, whether it’s overvalued in a longer term.
Technical traders tend to assess the market psychology through quantitative data analysis. Technical analysts tend to be more objective in drawing reasonable trading decisions. The use of market data in technical analysis like historical data, chart patterns, past trading activity, and market sentiment eliminates the basic assumptions. Traders then use the identified previous market patterns to predict future price trajectories. As such, TA is more suitable for short-term trading.
Still, to have the best of both worlds, traders are recommended to take considerations into technical and fundamental analysis to formulate a best trading strategy.
In technical analysis, the main goal is how to analyze cryptocurrency and predict future movement. The good news is that financial instruments follow their past price actions most of the time.
Keep in mind that no technical analysis is perfect, and using TA cannot guarantee you 100% accurate signals. Professional technical analysts always consider the weakness of every trading signal and keep a risk management system as a high priority.
Traders should understand the logic and reason behind every movement in a cryptocurrency and follow it with a trade management system. It requires time and effort to master technical analysis, but it will provide reliable profits once traders do so.