Crypto-trading - 101
So you want to be a crypto-trader, huh? You only have one question in mind : “When Lambo”? Look away now, this article is NOT for you!
— Troll: ON—
2017 & 2018 have seen so much fuss around crypto trading bot and crypto technical analysis. So many funky concepts we’ve all heard of like “dead cat bounce” or “Fibonacci Retracement” and people making millions by “reading the charts”. So many price analysis from Cointelegraph trying to light a glimpse of hope in your eyes in this bubble-bursting era.
Obviously, if the resistance is crossed and becomes a new support completing a 360 degrees Mount Fuji pattern while the small elves dance around the fire pit, then the ETH will break towards $900 or $1200, however if the moon turns red and we see a reduce volume then it might fall down to $300 but, hey, HODL to the moon my friend.
— Troll: OFF —
Over the last few months, your obedient servant has tried to build a trading bot with more or less success (1). It was clear that this should not replace any fundamental analysis on any asset I was planning to invest on, however the goal was to try to play on the high volatility of the crypto assets to quickly detect some shifts and buy/sell accordingly. After scanning through the arcanes of the web *cough* tradingview.com *cough* and this very complete guide it became clear that the very basics of the technical analysis should rely on the following:
1- Detecting Trends/Pattern
- Are we in a uptrend or downtrend situation?
2- Analyzing Volume
- Is the rally/drop real of phony?
- Is the rally/drop losing momentum?
3- Finding Boundaries
- Is it the right time to buy/sell?
1- Detecting the trends with Moving Averages, MACD & RSI
Moving Averages & MACD (2)
Remember back in 1st grade — or 4th grade for the slowest of us — when you got exposed for the first time to the magic of mathematics? Well the most basic and oldest trading techniques doesn’t require much more knowledge than what you learnt back there.
Sorry, I skipped 1st grade, what the heck is a moving average? A moving average is a mathematical average of the last X past data points, X being a number set by the user depending on how far back he wants the average to go.
For crypto-trading we will focus on two types of averages:
Simple Moving Average (SMA): Average where all data points have the same weight. Because it doesn’t emphasize on the most recent data points, it helps detecting longer term more robust trend changes but takes longer to detect them.
Exponential Moving Average (EMA): Average where the most recent data points have a much higher weight than the older ones. Faster to detect trend changes but these are less secure and could be false alarm.
On the example in Image 1, we can see that the shift from a down-trend to an up-trend in the ETH price is picked up much faster by the EMA (Blue line) than by the SMA (Red line).
Goal: The goal of moving averages analysis is to detect a change in trend of the price of a given asset. I.e.: Are we shifting from a down-trending price to an up-trending price or vice-versa?
How does it work? To do so, it compares a moving average spanning over a long period (often 50 days) with a moving average spanning over a shorter period (often 25 days).
This is what the Moving Average Convergence Divergence (MACD) aims at capturing. The MACD is a simple difference of short term moving average with a long-term moving average. MACD helps spotting two types of moments:
- Divergence: When the security price diverges from the MACD, it signals the end of the current trend.
- Crossover: When MACD crosses signal line (default: 0) Indicates it’s time to buy or sell
In the example above, with an MACD comparing a SMA(25) with an SMA(50) we can see the cross-over properly showed the move from down-trend to an up-trend and the divergence outlined the end of the up-trend on the ETH price.
Moving averages & MACD are among the simplest and oldest trading indicators and therefore are incorporated in all basic trading strategies. If they help detecting trends, they cannot help you make the difference between a real shift in trend and a fake bounce/drop. Therefore they should not be used alone and must be completed with additional indicators.(3)
Relative Strength Index (RSI)(4)
How do we compute it?
- RSI = 100–100 / (1 + RS)
- Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame (default = 14)
Goal: Relative Strength Index (RSI) provides another type of trend reversal explanation. RSI helps understanding if a given security is overbought or oversold.
How does it work? The rational is quite simple, any security that goes up will eventually go down and reciprocally, any security that goes down will eventually go up.
A security that goes up will stop going up when it will become too expensive for new buyers to acquire it and no more buy pressure will push the price upwards. The security is overbought which usually translates in an RSI > 70.
Conversely, when all the sellers have gotten rid of their stock and the price of the security is too low for new sellers to get rid of it, the price of a security will stop going downwards. The security is oversold which usually translates in an RSI < 30.
Case study: The April 2018 bounce back
In the chart above we clearly see that mid-April the ETH was oversold with an RSI < 30 and the Short Term EMA crossed over the Long Term EMA translating into a positive MACD. This translated into the restart of the ETH growth.
Trend reversal is key to detect when to invest however it can also easily be misinterpreted if not enough volume accompanies a given switch. Volume analysis is key to complete trend detection and must be included in any investigation framework.
2- Confirming the trend with volume analysis (5)
The most basic rule about any volume analysis is: Strong trends implies strong volumes. The main question is: How do we detect whether or not the volume we see is “strong”?
On-Balance Volume (OBV)
OBV is the simplest volume indicator you could think about. Starting from a random point in time, you add or remove the daily/hourly volume to the OBV depending on whether or not the closing price of that period was higher or lower than the previous period. In details:
- If today’s closing price is higher than yesterday’s closing price, then: Current OBV = Previous OBV + today’s volume
- If today’s closing price is lower than yesterday’s closing price, then: Current OBV = Previous OBV — today’s volume
- If today’s closing price equals yesterday’s closing price, then: Current OBV = Previous OBV
Studying the OBV lets you find whether or not there is an acceleration or deceleration in the bullish/bearish trend and helps you find the pivoting point where you should sell/buy.
Accumulation-Distribution Line (ADL) & Chaikin Oscillator
The principle behind the Accumulation-Distribution Line is easy to grasp, it aims at understanding whether or the buying pressure (accumulation) or the selling pressure (distribution) is the strongest on the market. It was invented by stock broker — Mark Chaikin.
The major difference with the OBV relies in the fact that the volume over the period is weighted by the Money Flow Multiplier which is an indicator that measures how “large” the “victory” of the buyers or the “sellers” is at the end of the period.
Imagine a football game between the 49ers and the Broncos. If the 49ers score 4 touchdowns and win 28–0 (very unlikely…), you’ll say the 49ers crushed the Broncos and would give more credit to this victory than if the Broncos came back and final score was 28–27 for the 49ers (very unlikely again…).
Money Flow Multiplier tries to reproduce this logic. Imagine a game between the buyers and the sellers where the buyers try to raise to get a close price higher than the open price and the sellers try to do the opposite. If the sellers manage to get -4% early in the morning and finish the day at -4%, you would give them more credit than if the buyers make a come back in the afternoon and the price closes at -0.3%.
The ADL can now be computed like this:
- Money Flow Multiplier = ((Close — Low) — (High — Close)) / (High — Low)
- Money Flow Volume = Money Flow Multiplier * Volume
- ADL = Previous ADL + Money Flow Volume
It can now be used to detect trends and specifically divergences (same as MACD)
The Chaikin Oscillator is actually an additional analytics layer you can add on top of the ADL to transform it into an MACD-like metric and find divergences more easily. On top the ADL calculation detailed above it adds a difference between a short-term EMA (Default = 3 periods) and a longer-term EMA (Default = 10 periods). It can then be used similarly to MACD to detect acceleration, deceleration or changes in trends when crossing 0.
We now have price indicators helping detecting trends and volume indicators to reinforce this first signal. The last part of our job is to find the right buy & sell limits.
3- Finding the boundaries to know when to buy/sell
If the last 1800 words looked fuzzy to you. Stop reading. Mow. What’s coming next is much closer to wizardry than actual analytics. Still some patterns seem to reproduce over time and technical traders try to sniff them, or is it because they try to sniff them that these patterns get reproduced? Chicken-egg, egg-chicken…
Fibonacci retracement (6)
Let’s start by a quick reminder of who Fibonacci is and why he is famous. Fibonacci was a mathematician from the 13th century who is mostly known for finding the magical Fibonacci numbers. The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms, and the sequence continues infinitely. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. Therefore ratios between any number n of the sequence and number n-1, n-2, n-3 is stable, no matter which number you pick.
Why do we care? Totally unclear but for whatever reasons it seems that technical traders believe that these ratios can be used to detect support between a bottom and peak values over a period of time. These supports are set at 38.2%, 61.8% & 86.4% down from the peak.
In case this doesn’t convince you, you can also use the famous 50% ratio that gets added to this list even if it doesn’t match any ratio between any number from the Fibonacci sequence.
Ascending & Descending Triangles
Whether it is in the catholic Trinity or with the Illuminatis eye of Providence, triangles carry some sort of mysticity. Technical trading cannot escape that. Detecting ascending & descending triangles can help you decide whether or not it’s a good time to buy or sell.
As you can see above, a security price bouncing on a resistance/support several times with a drying volume and a reducing volatility can signal a positive/negative breakthrough coming soon. In the former, buying would make sense while in the latter, selling/setting stop-loss seems to be the right course of action
Symmetrical Triangles
Similarly to the above, a symmetrical triangle with a decreasing volume would indicate a breakthrough is about to happen without any specifications on the direction of such breakthrough.
Flag & Pennant
Taking a step back from the triangles described before, we can also look for a longer term trend by searching a “Flag & Pennant” pattern. In a Flag & Pennant pattern, the security price observes a small consolidation that can be spotted with an ascending/descending triangle before continuing on the same trend.
Head & Shoulders Reversal
No, this is not an anti-dandruff pattern nor this is a pattern sponsored by Procter & Gamble. A Head & Shoulders Reversal pattern describes a failure to breakout and a trend reversal.
As you can see above, a H&S reversal pattern will be composed of three heavy price variations respectively the Left Shoulder, the Head & the Right Shoulder, all of them failing to breakthrough the resistance or the support of the security price. These three spikes come with a heavy volume and they never fall/raise below/above a support/resistance called the neckline. Once the H&S Reversal pattern is complete, the trend reversal can happen giving the traders a good signal to buy or sell.
As you can see, finding the right signals to buy & sell is far from being a rigorous science and requires some creativity. If you want to dig deeper into it or patent a new pattern name, feel free to go to stockcharts as they have one of the most complete overview of what already exists.
Conclusion
Over the last 10 minutes we have covered many indicators ranging from prices to volume and going through chart analysis but to summarize it in simple advices:
Don’t Overanalyze It: Technical analysis is not the be-all end-all of trading. It’s a tool to help you. Studying charts for hours trying to find patterns is not what’s going to make you money.
Trading boils down to many small losses and one big win. Good traders don’t get more than 50% of correct bet but the one they get correct outpace the losses.
(1) Using enigma-catalyst to back-test my trading-bot strategies (review of Enigma can be found here). It is very complete for testing but not stable enough to be used in production with the most common exchanges like Coinbase yet. Feel free to ping me if you have any additional questions.
(2) More details on Moving Averages: https://www.investopedia.com/university/movingaverage/movingaverages1.asp
(3) More details on Moving Averages & MACD limits: https://www.investopedia.com/articles/active-trading/100115/why-macd-divergence-unreliable-signal.asp
(4) More details on RSI: https://www.investopedia.com/terms/r/rsi.asp & https://www.investopedia.com/articles/active-trading/042114/overbought-or-oversold-use-relative-strength-index-find-out.asp
(5) Volume indicators: https://www.investopedia.com/articles/technical/02/010702.asp
(6) Fibonacci retracement: https://www.investopedia.com/ask/answers/05/fibonacciretracement.asp
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