What is Technical Analysis?

Photo by Pierre Borthiry — Peiobty on Unsplash

When navigating the wild ride of cryptocurrencies, two main analysis approaches emerge: technical analysis (TA) and fundamental analysis (FA).

In this article, we will cover the fundamentals of TA for beginner crypto traders, the different trading strategies that benefit from advanced TA, and also the pros and cons of TA in crypto trading.

How does technical analysis work?

TA refers to the analysis of price history and market activity of an asset to predict future movement. FA, on the other hand, takes a step back, examining a crypto’s underlying value based on its technology, purpose, and real-world usage.

Critics liken TA to reading tea leaves but proponents argue that this objective approach shields traders from trading based on emotions, which is the biggest factor that leads to losses.

In fact, TA, which is widely used in traditional stock markets, translates surprisingly well to the world of crypto. Here’s why:

• Both rely on price and volume data: Just like stocks, cryptocurrencies leave a trail of price movements and trading volume. TA analyzes these trails to identify patterns and trends that might repeat themselves.
• Psychology matters in both markets: Whether it’s stocks or crypto, traders are human. TA takes this into account,using historical data to understand how emotions like fear and greed can influence buying and selling behavior, potentially leading to predictable price swings.
• Focus on technicals, not fundamentals: Unlike stocks, where company financials play a big role, cryptocurrencies are more driven by pure market sentiment (especially when it comes to altcoins.) TA perfectly aligns with this focus on technical price movements rather than underlying company value.

Technical analysis rests on a few core principles and assumptions:

• The market discounts everything: This theory suggests that all available information, including fundamental factors and future expectations, is reflected in the current market price.
• Price moves in trends: The market exhibits a tendency to move in established trends, either upwards (uptrends) or downwards (downtrends). Identifying these trends allows traders to potentially capitalize on them.
• History repeats itself: Technical analysts believe that past price patterns tend to repeat themselves, offering clues about future price movements.

Technical analysis tools & indicators — where to start

What are the main categories of tools or indicators/metrics traders use when it comes to performing TA? Here are some of the most common ones:

• Charts: Price charts depict price movements over time, allowing for visual identification of trends and patterns. Popular chart types include candlestick and line charts. Candlestick charts are particularly popular because they show the opening, closing, high, and low price for a specific time period e.g. 15-min, one day, one hour or one week).

Within candlestick charts, traders look for recurring patterns that might signal future price direction. Some common patterns include head and shoulders, triangles, and flags.

• Technical indicators: These are mathematical formulas that analyze price and volume data and translate it into lines or signals on the chart. Beginner traders can start to pick up some fundamental indicators such as the following:
• Moving averages: These smooth out price fluctuations to reveal the underlying trend.
• Relative Strength Index (RSI): This measures the momentum of price movements and indicates potential overbought or oversold conditions.
• Bollinger Bands: These bands depict price volatility, with price movements typically staying within the bands.
• Support and resistance levels: These are price levels where buying or selling pressure is likely to be concentrated, potentially leading to price reversals or continuations. Support is a price level where there are usually enough buyers to stop the price from falling further. Resistance is a price level where sellers might jump in and start selling, pushing the price down.
• Trading volume: This refers to the amount of cryptocurrency being bought and sold within a specific timeframe.High trading volume often indicates strong buying or selling pressure, which can influence price movements.

Pros and cons of technical analysis

Perhaps the biggest advantage of TA is that it provides an objective framework in a manner that enables traders to remove emotions from their trading decisions when it comes to:

• Identifying trends: TA can help you spot trends in the market, allowing you to potentially ride rising prices (uptrends) or avoid falling prices (downtrends). There’s a big “but” here, however. Read on below to learn more.
• Timing entry and exit points: By analyzing charts and indicators, you can try to identify good times to buy (entry points) and sell (exit points) your crypto holdings.
• Short-term focused: Crypto markets are known for their volatility, and TA is well-suited for analyzing these short-term price movements.

However, it’s not a silver bullet, as TA involves the following:

• False signals: TA indicators aren’t perfect and can sometimes generate misleading signals, leading to bad trades. In fact, some TA indicators are lagging indicators; this means that they react to past price movements and trading volume, providing confirmation of a trend rather than predicting where the price will go next. They can be valuable for gauging trends and potential entry/exit points, but they shouldn’t be relied on solely to forecast future price movements.
• Limited scope: TA only considers price and volume data, ignoring other factors like news events or regulations that can impact the market.
• Subjective interpretation: Different traders can interpret chart patterns and indicators differently, leading to conflicting conclusions.
• Not fool-proof: The crypto market is inherently unpredictable, and TA can’t guarantee successful trades.

In conclusion

TA can be a valuable tool for crypto traders, but it’s not a crystal ball. It’s important to be aware of its limitations, especially if you’re just starting out. The crypto market is volatile, and even the best analysis can be wrong. As such, don’t go all-in based on a single indicator.

TA is most effective when combined with fundamental analysis and staying up-to-date with the market, like keeping an eye on relevant news and developments in the crypto world.