Understanding Technical Analysis

Technical Analysis (TA), also known as charting, is a method of analysis that uses historical price action and volume data to predict future market behavior. The concept behind TA is that all elements (micro & macro factors, market psychology, natural catastrophes) are discounted in the price of an asset. TA is usually applied to traditional markets such as forex, stock trading, and commodities trading. Still, it is an essential part of trading cryptocurrencies that can be used to generate favorable trading opportunities.

Basics of Technical Analysis

TA studies historical price movement and volume data to predict future market movement. TA users rely on charting patterns and indicators known collectively as indicators. These tools enable them to identify existing trends and predict future market movements. Moreover, TA is mainly used by traders to create short-term trading signals.

There are three main assumptions that enable TA to function:

1. The market price discounts every element of an asset

2. Price movement is not random and can form identifiable trends over time.

3. History repeats itself.

The core of TA is an analysis of market supply and demand forces. Essentially, the price of an asset is driven by the opposing sellers and buyers (bulls and bears), which are intern driven by market participants’ sentiments influenced by their emotions and psychology (mainly Greed and Fear).

TA is usually reliable in a market with high trading volume and liquidity because it is less susceptible to market manipulators or abnormal trends that may result in false signals.

Technical Analysis and Cryptocurrencies

Traders can employ a variety of indicators when doing TA applicable in both traditional and cryptocurrency markets. Below are some of the common and basic indicators used in TA.

• Trends & Patterns: A trend is the market's general direction for a given period of time. TA analysts usually look at trends from 2 main angles (primary and secondary trends). Moreover, patterns are formed by sets of data following a recognizable form used to predict a market trend's future direction.

• Candlesticks: TA users use mainly Japanese candlesticks charts to visualize price actions. Candlesticks are analyzed from the shape of their body and secondly as a collective set to see what type of patterns are formed.

• Volume: Volume measures the total quantity of shares for a given asset within a given trading period. Volume can be used to indicate the strength of price movement in a particular direction. For example, if there is high volume in a given candlestick price, this would indicate strength in the price movement of that candlestick, whether to the upside or downside.

• Moving Averages (MA): MA’s are the most common types of indicators which appear in different variations, mainly Simple-MA(SMA) or Exponential-MA(EMA). MA’s are mainly used to determine the trend direction of a given market or asset.

• Relative Strength Index (RSI): RSI is a momentum indicator that measures the magnitude of a recent price change relative to the previous price move. Essentially, it compares the strength of one candlestick within its set time period to the previous one on a scale of 0-100; 30 is commonly used as an oversold signal, and 70 is an overbought signal.  

Pros and Cons of Technical Analysis

Pros

Market participants need a method for estimating the best entry and exit signals in a market, and TA provides the tools for that. Moreover, as technical analysis gains widespread usage, more traders will likely find similar entry and exit signals. Hence, traders will be concentrated around the same area, inevitably creating repeated patterns.

Cons

No one can predict the future with 100% certainty, not even TA. Moreover, TA relies on historical data to predict future market movements; even though trends can be identified from historical movements, the future will always have an unforeseeable element.

Furthermore, TA is criticized as being a “self-fulfilling prophecy.” Critics claim that TA only works because many traders rely on the same indicators; thus, it increases their chances of coming to a common prediction of future market movement.