Investing with Indicators
Technical Trading & Cryptocurrency
Our brains are conditioned to interpret the world in a particular way. When we look out the window and see a yellow flower a process is initiated. Light is reflected from the flower and into a light-sensitive retina in the back of our eye. This stimulates millions of photoreceptors to send nervous impulses to our brain, which then relays the colour — yellow. Analysing information like site, sound, smell and touch has been vital to our survival and thus, we have become exceptionally good at it.
However, the process of analysing financial markets is not as easy for most individuals… which makes complete sense. I mean, when we were being chased by Saber Toothed Tigers millions of years ago, being able to spot technical movements in the underlying value of an asset was not important. Today, however, it is. Given we don’t have hundreds-of-thousands of years to wait for our brains to adapt we must create shortcuts to notice patterns that have, in the past, indicated specific future price movements. This is the theory behind technical analysis.
This article will aim to explain some of the most common patterns used in crypto based technical trading. It should be understood that technical analysis is inherently risky and combining multiple sources of data is recommended to mitigate against risk.
Japanese Candlesticks are used in cryptocurrency trading because they combine key data points into a single price bar. Although cryptocurrencies are considered alternative assets (relative to traditional debt and equity) their price actions are still charted with open, high, low and close (OHLC) values. These data points are combined to create candlesticks, which help build patterns and predict future movements.
Based on back testing, the most accurate candlestick patterns are those that predict ‘reversals’ and ‘continuations’. Reversals predict changes in price direction whereas continuations predict persistence.
Given the cryptocurrency market tends to show a strong upside bias, traders should focus on patterns that predict troughs or upward continuations. Note, as the market becomes more consolidated these biases will likely become less pronounced.
For educational reasons we will assume a continuation in the bullish market perspective (despite it recently showing a reversal to bearish movements.) The five bullish candlestick patterns investors should focus on are; The Hammer, The Bullish Engulfing Pattern, The Piercing Line, The Morning Star and The Three Soldiers.
The Hammer, is a price pattern in candlestick charting that occurs when a security is trading significantly lower than its opening, but rallies later that day to close either above or near its opening. This pattern forms a hammer shaped candlestick, in which the body is at least half the size of the tail or the wick. Hammers signal a reversal upward in price and are most effective when they are proceeded by multiple declining candles. The Hammer is the antithesis of ‘The Hanging Man’, which signals a reversal downward following a price rally.
The Bullish Engulfing Pattern, is a candlestick pattern that occurs when a small black candle, showing a bearish trend, is followed by a large white candle, showing a bullish trend. The body of the white candle should completely overlap the body of the black, meaning the asset price must be lower on day two than what it closed for on day one. If volume also increases with the price, investors may buy near the end of the day (expecting continuation the following day).
The Morning Star, is considered by technical analysts as a bullish reversal sign following a downward trend. A Morning Star consists of three bars. First, a tall red candlestick appears within a well defined downward trend. Second, a small candlestick (either red or white) closes below the first tall red bar. Third, a tall white candle opens above the middle candle and approximately halfway up the first.
The Piercing Line, candlestick pattern occurs when a bullish candle on day two closes above the middle point of day one’s bearish candle. Since the piercing line indicates the bulls were unable to completely reverse the losses of day one, more bullish investment might be expected in day three.
The Three Soldiers candlestick pattern consists of three consecutive long-bodied candlesticks that open within the real candles previous body and close higher than the previous candles high. This pattern is used to suggest a strong change in market sentiment.
Theories & Applications in the Cryptocurrency Market
The Elliot wave theory was devised in the 1920’s by Ralph Nelson Elliot and is one of the most widely used forms of technical analysis today. It describes the natural rhythm of crowd psychology in the market, which manifests itself in waves. In essence, the Elliot wave theory assumes prices fluctuate between impulsive and corrective phases. Impulsive waves are believed to reaffirm existing trends whereas corrective waves oppose the main trend. In its simplest form, an impulsive wave contains five lower degree waves while a corrective wave contains three lower degree waves.
The theory assumes the stock market is created by fractals, which are infinitely complex patterns that are self similar across different scales. Each set of 5+3 waves defines a complete cycle and within a cycle different patterns can be isolated. The most common patterns are ending diagonals, expanded flats, zigzag corrections and triangles. In total 15 degrees of waves can be identified.
In favour of saving time I won’t delve into the specifics but if you’re interested in learning more then a great book outlining the complexities and intricacies of this theory is called “Elliott Wave Principle: Key to Market Behavior” by A. J. Frost and Robert Prechter.
The Fibonacci Retracement theory is created by taking two extreme points (usually a peak or a trough) and dividing the vertical difference by the existing Fibonacci ratios (23.6%, 38.2%, 50%, 61.8% & 100%). Once these levels are isolated horizontal lines are drawn to identify potential support and resistance levels.
Stochastic’s and the Relative Strength Index (RSI) are indicators used in technical analysis that oscillate between zero and one hundred. They can be used in the cryptocurrency market to determine the strength of a trend or to isolate peaks and troughs that occur due to oversold or overbought conditions. This technique suits cryptocurrency trading because price fluctuations are largely driven by speculation.
During a prolonged downward swing the oscillators will move towards zero, indicating the trough of the market. During a prolonged upward swing the oscillators will move towards one hundred, indicating a peak in the market.
In the graph above Bitcoin is at an 81.92 RSI, indicating that Bitcoin is overbought and a correction should be expected.
The MACD indicator tracks the relationship between the moving average of two prices. It’s calculated by subtracting the 26-day exponential moving average (EMA) from the 12 day EMA. Next, a 9-day EMA of the MACD, (labelled the ‘signal line’) is plotted on top of the existing MACD, acting as a trigger for buy and sell signals.
There are three different signals used in MACD interpretation:
- Crossovers: When the MACD falls below the signal line a bearish signal is created. When the MACD rises above the signal line a bullish signal is created. Many traders will wait for a crossover before entering positions.
- Divergence: When the security price diverges significantly from the MACD it signals the end of an existing trend. For example, if the token price was rising and the MACD indicator was falling it may signal the end of a current rally.
- Dramatic rise: When the price of a token rises quickly and the short-term moving average pulls away from the long-term moving average a bearish signal is created, which indicates a future price reversal back to ‘normal’ levels.
Traders also monitor movements above or below the signal line because this represents the relationship between the short and long term moving average. When the MACD line falls below the signal line the short term average is below the long term average (indicating a potential future rally).
Ichimoku Cloud’s are used in technical analysis to show support and resistance levels, identify trend direction, gauge momentum and provide other trading signals. The ‘clouds’ are used to isolate bullish and bearish crossover points formed between spans of moving averages plotted six months ahead, and the midpoint of the 52-week high/low plotted six months ahead.
Developed by Goichi Hooda, a Japanese journalist, the clouds are designed to show more information than traditional Japanese candlesticks. In their simplest form, the clouds show an upward trend when the price is above their body and a downward trend when the price is below their body.
Conclusion: When analysing technical indicators it is important to understand the strengths and weaknesses of each theory. Understanding the investment market will help you isolate relevant indicators and understand potential price movements. Collating and synthesising data will help mitigate risk and is perhaps the most important step in the investment process.
Disclaimer: This is not intended investment advice. Please do your own research before investing. The nature of cryptocurrency is inherently speculative so only invest what you are prepared to lose.
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The purpose of ALTCOIN MAGAZINE is to educate the world on crypto and to bring it to the hands and the minds of the masses. This article was written and composed by Henry Gillett on ALTCOIN MAGAZINE.