Technical analysis (abbreviated as TA) is the strategy of interpreting an asset’s past price movement to guess where price will be in the future. It is a way of distilling market information to make a better decision on purchasing or selling an asset.
In its purest form, it involves looking at a chart, identifying price trends, confirming if the trends you see are valid, and making a trading decision based on that info. Sounds great—look at the charts, figure out the future price. Easy enough.
In reality, though, it’s a bit more tricky. Millions of market participants are playing the same game, all looking for an edge, all trading on their own psychology, with ridiculous amounts of static between the signal and you.
The Data Supporting Technical Analysis
A lot of more conservative ETF-type investors will tell you that technical analysis is totally meaningless. I don’t think this is the case. Plenty of academic (and anecdotal) evidence tells us TA outperforms passive investing strategies.
Most data we have on the discipline comes from equity markets. While there are definitely academics that say TA is worthless, the following studies have all confirmed that basic TA can outperform passive strategies:
Most recently, 2018 study de Souza, M.J.S., Ramos, D.G.F., Pena, M.G. et al. made the following conclusion on a broad review of TA strategies in BRICS equity markets:“On average, the returns obtained using technical analysis surpassed the value invested.”
These studies sometimes contradict each other, but pretty much all of them have commonalities:
- TA is more effective when performed in less efficient markets
- Higher frequency of trading is correlated with lower returns via TA
- TA aided by fundamental analysis is more effective
- TA is more effective in less mature markets
Perhaps these points help explain why TA is so effective in crypto markets, especially with altcoins. Altcoin markets are immature, less efficient, and can be evaluated fundamentally. Retail investors have a further advantage in that they don’t need to make frequent trades.
When is Technical Analysis Valid?
I don’t think the average crypto investor can make their whole trading career out of technical analysis, but it can definitely help you:
- Inform longer-term investment decisions alongside fundamental analysis
- Help you time exits
- Get better entry points for swing trades
All of these advantages are valuable enough that it’s worth understanding, at minimum, the basic foundations.
In this analysis, I’m going to be starting from the most basic TA concepts. If you already understand technical analysis, this article might just be a way to brush up on the basics or one to skip.
The Foundation: Supply and Demand
All technical analysis comes down to one thing: understanding supply and demand. If there are more buyers (demand) than sellers (supply), the price will move upwards. More demand than supply? The price will go up. Much of technical analysis comes down to identifying where that supply and demand lies and making your investment based on that info.
I find it a healthy exercise to reflect on the fact that, in every trade, there is one buyer and one seller: for any investment idea you have, there is someone on the other side thinking the exact opposite. And one of you will be wrong. It’s a humbling concept, but one that will definitely make you think twice.
When a cryptocurrency bounces off a certain price level twice, that could indicate a place of resistance or support. That is to say, there are a lot of people looking to trade at that price and the crypto will have a harder time breaking out above or falling below.
Resistance is the tendency for an asset to approach a given price and fall back down just before or right after hitting it. It often happens at round numbers, because sellers concentrate supply around prices like $100 or $1000 or $60,000.
Check out the example below where Bitcoin bounced off of its previous all-time high (resistance) before breaking through:
Once a crypto breaks through a resistance price level, it often becomes support. Support is a floor that an asset’s price bounces off. This can represent a good buying opportunity because frequently, after a crypto makes this critical test, momentum changes. Many investors wait for that bounce to make a directional trade and buy at the lowest possible price.
For an example, check out the chart below for Ethereum, where it broke through, then bounced off, the $3,000 price level for a few weeks.
I like this tweet from Three Arrows Capital investor Su Zhu on trading support and resistance:
Channels are just what they sound like, two walls of prices that an asset is range-bound within. Channels can trend up, down, or sideways. When channels trend sideways, it’s often seen as an opportunity to accumulate a crypto.When these channels exist, there are a few possibilities for making money:
- Make a trade at the bottom hoping for a bounce
- Make a trade at the top hoping for a rejection
- Make a directional trade after a breakout
A breakout happens when a crypto moves above a support area or below a resistance area. When identified correctly, this tends to be accompanied by a big move, either up or down, and thus a big opportunity. It happens a lot when a crypto hits, and then passes, an all-time high.
Below is a chart of Bitcoin last year where it encountered resistance at its 2017 ATH, then broke out with a big move to the upside:
Like price levels of support and resistance, moving averages are often areas of resistance and support as well.
Simple Moving Average
The concept of a simple moving average is, well, actually a little complicated: it is the “arithmetic moving average calculated by adding recent prices and then dividing that figure by the number of time periods in the calculation.” It’s basically the average price over the last period of time, plotted on a continuous line.
These moving averages end up being bands of prices that sit below the asset price in bullish times and above the asset price in bearish times.
If you’ve ever heard the term ‘death cross’ or ‘golden cross,’ it comes from moving averages. Golden crosses are when a short-term moving average crosses a long-term moving average to the upside, and often signals a pump in price. Death crosses are when a short-term moving average crosses a long-term moving average to the downside.
You can see the chart below as an example of what moving averages look like on a chart as well as what it looks like when they cross.
Exponential Moving Average
The EMA is similar to the SMA, although it places more weight on recent prices. It’s used in a similar way, to find buy and sell signals when it serves as resistance or support or when it crosses another moving average.
You know those little bars at the bottom of a price chart, below the graph? Those bars reflect volume, the amount of a given cryptocurrency, in dollars, traded over a time period. Volume can help us detect momentum—a word used when a trend in a cryptocurrency is accompanied by large volume. Increased volume signals that whatever trend you’re seeing is important.
With more volume, we can see that more and more participants are pricing in new information, and that more participants are entering or exiting the market for that asset. A price drop on very low volume probably isn’t a huge reason to be concerned. A price drop on enormous volume means there’s something big happening.
See the May Ethereum selloff for a good example of how high volume signaled a short bear market:
RSI, or Relative Strength Index, is a stat that ranges between 1 and 100 and attempts to show momentum. The calculation is a bit rough, but the basic idea is that if RSI is above 70, the crypto is overbought and might be due for a trend reversal. Below 30 and it could be undervalued, ready to pull out of a downward slide.
It’s a bit more nuanced and must be used in conjunction with price data to be well understood. The fact that cryptos can remain ‘overbought’ or ‘undervalued’ for long periods of time makes it even more difficult to get right.
Platforms for Technical Analysis
For charting, TradingView is definitely the most popular service and it’s free, although it’s got a premium subscription available. The charts in this article all came from TradingView. Coinigy and Cryptowat.ch are also well-known services. I’d recommend TradingView just because it’s so widely used.
The Limitations (and Infinite Possibilities) of Technical Analysis
Technical analysis is a tree that branches out in endless directions. On-chain analysts (market observers that look at public blockchain data) combine TA with other metrics. They combine these new metrics to make even more metrics derived from the first layer of TA statistics. It can make your head spin.
There are so many signals and patterns to identify that it often becomes difficult to find the patterns that are really important. As with everything, it comes down to practice, experience, introspection, research, and learning.
It’s really, really difficult to become a trader on solely technical analysis. When your money is on the line, it’s easy to get emotional or over-invested in a narrative. An altcoin that’s pumping is really hard to sell and will look like it can go forever. Stories can be constructed in your own head.
I think TA is best used in combination with other skills: position sizing, fundamental analysis, diversification, profit taking. It’s another way to improve your arsenal as an investor, not a golden bullet.