Investment Strategies in Cryptocurrency, Part 2: Technical Analysis
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In the vast world of investments, most strategies can be identified as either fundamental in nature or technical. In the last post, we explored fundamental analysis. Investors who focus on fundamental methods try to use data, other than solely price data, to assess the value of the investment. In this post, we will explore investment strategies based on technical analysis.
Watching traders and investors battle over which type of strategy is best is like watching The Avengers: Civil War. Here, you have two sides, all fighting for the good… assessing value and seeking positive returns on their capital. Yet, the Iron Man side holds to the letter of the law. This is much like the financial analysis-filled land of fundamental analysis. Then you have the Captain America side, with its ideologies and intuition, akin to the technical side of analysis. Both sides are seeking positive returns, but how they get there is completely different.
As a refresher, fundamental analysis is typically based on financial data other than solely market price. It includes ratios calculated based on the balance sheet and income statements. It can use market price, but typically in relation to profit or some other performance metric. In cryptocurrency, we pointed out the use of market cap, white papers, and usage metrics as a means of finding valuable assets to trade.
What exactly is technical analysis? Wikipedia actually provides my favorite answer, “an analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume.” In short, any investment analysis that attempts to forecast the future price by using past data on price is technical analysis. Many investors get their start in trading by studying technical analysis. Understanding chart patterns seems to be a bit easier than interpreting the financial statements of a company.
There are countless volumes of books on the subject. The one that I personally consider the “bible” is John Murphy’s “Technical Analysis of Financial Markets.” I actually have both the first and second editions. The book covers dozens of topics in technical analysis. It’s a great place to start, in case you’re looking for a book recommendation.
One of the most notable technical traders include Richard Dennis, the man who made a bet that he could teach a group of random people to become successful traders by showing them how to use trend following chart patterns (the group was known as the Turtles). Another, is James Simons of Renaissance Funds, a hedge fund that uses mathematics and statistics to generate high returns. In fact, he was the highest paid hedge fund manager in 2017, earning $1.7 billion dollars. Not bad for a year’s work!
Most technical analysts assume that there are mathematical laws at work. Some people will tell you that all of the information regarding an asset has already been priced into the market at any given time, so fundamental analysis is irrelevant. One thing I’ve always noted is that when a large group of people are expecting the market to move a certain way, often times their actions work to create the very movement they expect. We’ve certainly witnessed crowd hysteria based moves in cryptocurrencies. The move itself become the self-fulfilled prophecy of the traders’ expectations.
Many hedge funds use algorithms to trade the markets. Those algorithms are typically just the components of a trading strategy based on technical analysis. Black box trading models use technical analysis. High frequency trading typically uses technical analysis. “Quant” funds use technical analysis. If nothing else, technical analysis matters because so many players in the industry use it.
The types of technical analysis are wide and varied. For the sake of this post, we will cover three types. The first type is moving averages. The second type is chart patterns. The final type discussed is momentum/ volatility patterns. This will be a good intro to technical analysis. If you wish to go deeper, take a look at books on financial time series analysis.
When it comes to technical analysis, the same methods used to analyze stocks and futures are used in the cryptocurrency markets. Our discussion of fundamental analysis required different methods for the crypto markets. Because technical analysis simply uses price data, the skills and methods are transferable between many asset classes.
Moving averages are a great place to begin this journey into technical analysis. Moving averages are one of the more basic methods, both in terms of calculation and in terms of trading styles. A moving average is calculated by taking the price average over a period of time. The 200 day moving average is calculated by average the closing prices of the last 200 days. A 100 day moving average is calculated by calculating the closing price of the last 100 days. The values are “moving” because each new day creates a new data point to be plotted. The values of the averages create a time series that can help analyze current prices in the market.
The time periods that are used in moving averages are very significant. A 200-day moving average is used to identify longer-term trends. A 5 day indicator is better at identifying short term trends. A 5 minute indicator is an even shorter term trend indicator.
Moving averages tend to identify trends. If, for instance, the current price is higher than the 200 day moving average, the market is in an upward move. That’s proven mathematically because stock price is above the average closing price of the last 200 days. If price is lower than the 200 day moving average, the market is in a downward trend.
While you can use a single moving average to indicate whether prices have been heading lower or higher, most trading systems use them in pairs (or more). For example, let’s just say I am using a short-term moving average and a long-term moving average. If the short-term moving average is greater than the long-term moving average, that means prices are increasing. It simply shows that recent prices have been higher than older prices, a sign that the market has been increasing and will likely continue. If the longer-term price is greater than the short-term moving average, prices are lower. The near term prices are consistently lower than the older prices. If both averages are greater than the current price, prices are falling. If both moving averages are less than the current price, prices are rising higher.
The points where the moving averages cross over one another indicate a change in trend direction. These crossover points are often used as buy and sell signals. For instance, if the shorter-term moving average crosses above the longer-term moving average, prices are in an upward trend and it’s time to buy. A sell indicator is when the longer-term moving average crosses above the shorter-term moving average.
This simple moving average crossover strategy can be used for big moves (200 day vs 100 day) or smaller moves (10 day vs 50 day), It can even be used with ultra short intraday data (5-minute vs the 15 minute). The shorter the time frame used, the more trading signals this strategy will produce. That being said, it’s important to look at how your strategy has performed in the past. False signals, times when the moving averages cross but the market prices do not move in line with the expectation, can lead to a series of bad trades that cost you money.
The image above is the Ether Token (WETH), using Tradeview via ERC dEX. The points where the purple line, a 50 day moving average, crossed above the red line, a 20 day moving average, provided traders with a clear indication that prices were primed to head lower. It’s best to test different moving average settings for your own trading style.
When you mention technical analysis many traders instantly think of chart patterns. This type of technical analysis is one of the most common, and many people have signals and indicators they swear by. We will cover some of those concepts in this part of the post. We will touch on four different types of chart patterns. The first will be support and resistance lines. Next we will cover trend lines. We will follow with reversal patterns and then finish up with continuation patterns. There are books written on each of these topics. We will only scratch the surface here. Feel free to dive deeper with books to learn more about the topics.
Support And Resistance
Support and resistance signals are exactly as they sound. Support levels indicate where there has been buying strength in a market. This means that prices have fallen to a level where investors historically think the asset is a good buy. Support levels are normally visible when looking at a chart. Often times you can draw a horizontal line that touches several “low” points in the market and then rallies from there.
There are a few different trading methodologies for support lines. You can buy in advance, fully anticipating the support to create a lower price boundary (with limited risk). You can wait for the support level to be tested and then purchase once the market appears to be going higher. You can also wait to see if the support level fails, indicating that prices are heading lower. If support fails, you would look to sell the market.
Resistance lines are similar to support, except they are used at a high point in a market rather than a low point. The market is signaling a level other traders are resistant to trade above, i.e. a maximum value. Like support lines, a resistance level should touch multiple points on a visibly horizontal line along “high” points in the market.
The trading methods for resistance are similar to the ones stated for support levels. You can sell the market near the resistance levels, fully expecting investors to sell at the resistance line. You can sell the market after the resistance level has been tested and has held. Or, you can look to buy the market if prices move through the resistance level (hopefully to create a new high). Even if you’re not keen to actually trade them, it’s always good to be aware of support and resistance levels in your market.
Trend lines can be a very useful tool for technical analysis. Trend lines are drawn to confirm the existence of prices moving in a consistent direction. Trend lines can be upward or downward. The information received from a trend line is valuable, regardless of direction.
To draw a trend line, draw a line along the highest points on a price chart. Then, draw a line along the lowest points. If the prices seem to clearly stay within the boundaries of your upper and lower lines, you have a trending market. An upward trending market is noted by higher highs and higher lows. A downward trending marking is indicated by lower highs and lower lows. If the trend appears to be horizontal, that market is said to be in a channel.
Trading a trend line is typically based on two concepts. You either trade in a way that supports the continuation of the trend. Or, you place a trade expecting the trend to end. If you intend to support the trend, you would buy in an upward trending market and sell in a downward trending market. If you expect the trend to end, you would wait for the market price to break the trend line and sell (buy) the upward (downward) trend lines. Much like support and resistance, channeling markets can give you an indication on maximum and minimum values for the market. Trade accordingly. And remember, “the trend is your friend!”
As you can see by the above image of WETH, identifying trends can be helpful for two reasons. First, it gives you a good sense of where the market may be heading. Second, it can give you visual validation that the price pattern has changed and a new, powerful move may be beginning.
Reversal patterns make up another significant portion of the chart patterns. Just as the name suggests, reversal patterns indicate a period when the trend is about to go in the opposite direction. In fact, there are technical traders that identify as either trend followers or reversal traders. Being able to identify a change in direction in the market is a very valuable talent to craft.
The goal of a reversal pattern is to successful identify a top or bottom of the market. The top of the market is the highest price it will go before falling much lower. The bottom of the market is the lowest point prices will go before rising higher. While there are hundreds of details for identifying these points, we’re only going to mention a couple patterns here. If you are interested in learning more, definitely do some research to find books and classes where you can learn.
One of the most popular patterns is the classic head and shoulders pattern. This pattern is identified by two peaks of similar value (the shoulders) with a higher peak between them (the head). These can occur at the top or bottom of the market. A head and shoulders top will have two high points with a higher peak in the middle. It will occur at the high point of market action for a period. It indicates that prices have maxed out and are about to head lower. A head and shoulders bottom consists of two lower peaks with a lower peak in the middle. This can occur at the low point of market prices. It indicates that prices have reached a bottom and are about to head higher.
In the image above of WETH, you can see the head and shoulders pattern. The red arches are indications of the three signals we look for to identify this pattern. The blue line is a support line that held for several of the previous low points. Once the support line is “broken”, you would look to sell the token. As you can see, within a couple weeks of breaking the support line, prices fell significantly.
Another strong reversal pattern is the double top and double bottom. Much like the head and shoulders pattern, this pattern is a visible indication that prices have pushed as far as they can and are about to go the opposite direction. You’ll hear some of the talking heads discuss double tops and bottoms on financial broadcasts.
A double top is made of two high points in a market of roughly the same value. You might even be able to draw a resistance line between them. It’s a signal that prices just don’t have enough steam to push higher at the moment. You typically expect prices to head much lower after the second price attempt weakens at the same price point.
A double bottom is just like a double top, just on the lower end of price action. You will see two low points in price near one another at roughly the same level. You may be able to draw a support line between them. It’s an indication that prices have reached their low point and are likely to push higher from there.
This next reversal technique is a little more quantitative. Retracement levels give traders a likely expectation of how long a reversal pattern will last. Once a reversal pattern has been identified, retracement levels help traders calculate expected profit and mark possible exit points in the trade. The first retracement level is fairly simple. The 50% retracement level is always one to be aware of. This is calculated by calculating the price value of the last major trend and calculating the midpoint. The concept is that prices will correct or retrace to half the size of the last trend before making a new direction.
Another retracement technique is Fibonacci analysis, a technique whose namesake was a mathematician in the Middle Ages. Fibonacci analysis attempts to identify how far a reversal pattern will go in price. The technique is thought to be recurring throughout nature. It has been applied to the financial markets since the 1960s approximately. The basic concept is that certain levels are repeated. The 38.2 and 61.8 levels are the main retracement levels used by people who use Fibonacci analysis in the markets. This means that they expect prices to retrace to 38.2% of the last major trend. If prices push strongly beyond this point, the next level to watch for is the 61.8% retracement level.
Just to make this clear, let’s say ethereum moved from $815 to $185 in the last major price move. The value of the trend is the difference $630. To calculate the 50% retracement we will take half of the value of the trend and add it to the low point. We will do the same for the Fibonacci retracement levels.
Trend: $815 — $185 = $630
50% Retracement: $630 / 2 = $315 , $185 + $315 = $500
38.2% Retracement: $630 x 38.2% = $240.66 ; $185 + $240.66 = $425.66
61.8% Retracement: $630 x 61.8% = $389.34 ; $185 + $389.34 = $574.34
We now have expected retracement levels for Ethereum. The 50% retracement level is $500. The 38.2% retracement level is $425.66. The 51.8% retracement level is $574.34. These would be levels of interest if the market turned higher and ended the downward market move.
Continuation patterns are meant to indicate that the previous trend is not finished. The most commonly used continuation patterns are triangles and pendants. Just as they sound, these chart patterns exist when prices literally make what appears to be a triangle or pendant. If prices push higher, then fall to a base level, then push higher again and fall to that same base price, then push even higher, it will look like a triangle. Flags and pendants are similar in that they are visible patterns created by market pricing.
MOMENTUM / VOLATILITY
Our final section is on market momentum indicators. Each of these indicators get into higher level mathematics. Because of this, many charting patterns have them pre-coded into the platform rather than having to calculate them by hand. The most important thing when using a momentum indicator is that you fully understand what the output is telling you. Your ability to interpret the output will define your success in using these in your trading techniques. Here are a couple that are worth considering:
MACD — Moving Average Convergence Divergence
RSI — Relative Strength Index
The MACD indicator has long been one of my favorite momentum indicators. This indicator uses the difference between two exponential moving averages (EMA), such as a 26-day and a 12-day EMA. This difference is plotted on the chart and creates a line. Typically a shorter term EMA, like a 9-day, is used as the signal line. When the two lines cross, that indicates a buy or sell indicator, depending on the location of the cross to the “zero-line”. The position of the MACD line above or below the zero line is also an indicator of whether a market is overbought or oversold.
Once again using the WETH price chart, the image shows the crossover indicators that came before changes in the trend.
The Relative Strength Index is similar in use to the MACD. It is also plotted beneath the price chart as well. If you’d like to learn more about the MACD and the RSI, Wikipedia is a good place to start. You can find the MACD page here, https://en.wikipedia.org/wiki/MACD , and the RSI page here: https://en.wikipedia.org/wiki/Relative_strength_index .
I know several traders who swear by both of these indicators as a sign of price reversal or even trend continuation.They can be very useful tools. Try them out in your analysis to see if they add value.
Another tool used in cryptocurrency trading is the speed of trades indicator. This can let you know when an unusually high volume of trades are happening in a currency and can signal unsustainable pricing. Depending on your trading style you will either dive in or stay on the shore during these periods and wait for the true trading pattern to reveal itself.
You can spend a lifetime learning new techniques to analyze trades. Whether you use fundamental analysis or technical analysis, the most important thing is finding a style that works for your personality and lead to success in trading. It all comes back to results! In parting, I suggest using a handful of techniques together that will confirm your analysis. Remember, this is meant to help your trading. So if you do so much analysis that you don’t make trades at all, your analysis is causing paralysis. Happy trading!
About The Author: Eric Lewis is a self-proclaimed finance junkie with 17 years of trading experience. He began his trading career focused on index option trading at the CBOE in Chicago, where he spent 5 years as a market maker. He entered the energy business after graduate school, focused on structured notes and origination. He then settled into fuel trading, with a focus on gasoline and ethanol. Eric has a weekly podcast on option trading and has turned his focus onto the cryptocurrency trading world. He has a BA in Economics from the University of Texas at Austin and an MBA in analytical finance from the University of Chicago.