3 Technical Indicators in Trading Cryptocurrencies
It would have been irrational not to note that bitcoin and cryptocurrencies which operate on a 10 year old blockchain protocol recently made a sporadic increase in the market owing to the recent attention Facebook’s proposed cryptocurrency (Libra) brought to the ecosystem.
While there exist, arguments as to the validity of Libra as a Crypto asset, more funds have come into the market from parties who FOMO. This however, might have inspired the bitcoin price rally since July 2019. Given what we have seen of the crypto market in general, there can certainly be meaningful trading opportunities given proper research, understanding, and action. However, how would you know when to enter the cryptocurrency market? Should you take a position on a particular cryptocurrency now, or hold off? This is where technical analysis may assist traders with assessing, analysing and answering these common questions.
In this post, we will explore three commonlly used technical indicators that are applied in trading cryptocurrencies. Moving Averages, Fibonacci Retracement and Relative Strength Index. It will not be out of place to also illiustrate some points of application usuing various market pairs.
What is Technical Analysis?
Technical analysis is simply the use of data from previous price movements to predict future price movements. It is the technique used by traders to analyse identity patterns and signals that form on price charts and and to in turn to determine how asset would move in the future. Technical indicators are usually automatically calculated and applied for you on most charting applications.
Technical analysis is based on three main assumptions:
1. Markets already fully value the asset and price movements are due to the forces of demand and supply.
2. Prices move in trends.
3. Prices often follow predictable patterns due to market psychology.
In the eyes of most people, technical trading is a ver calculated and statistical style of trading. Since technical indicators are more precise for short term price movements, they may be used for day trading and swing trading (where traders hold assets for a short period – i.e. generally 1 to 2 weeks).
We now turn to three of the more popular and commonly used technical indicators in trading cryptocurrencies.
The moving average of an asset can be seen as a trend following indicator which tells you about the price level of an asset based on its previous prices. The moving average is calculated over a certain number of fixed time intervals, and common time periods used are the 50 day and 200 day moving averages.
The moving average is graphed as a line on the price chart of a cryptocurrency. There are two types of moving averages, the simple moving average (“SMA”) and the exponential moving average (“EMA”).
The SMA is calculated using an average of the previous prices divided by the number of time periods, and therefore provides the average of price data.The EMA is calculated using the SMA but with a weighted average which favours more recent prices.
In this manner, the main difference between the SMA and EMA is that under the EMA, recent price data will affect the moving average more, and older price date will have less impact in the calculations.
Fibonacci Retracements are horizontal lines that divide the distance between two extreme points on the price chart according to the Fibonacci ratios: 23.6%, 38.2%, 50%, 61.8%, and 100%.
Fibonacci Retracement lines are drawn by:
Identifying the highest and lowest price in the time frame that you are interested to analyze and drawing horizontal lines at each of these price levels
Divide the distance between those lines by the Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%) and draw a horizontal line at each level.
How do you interpret Fibonacci Retracements?
Fibonacci Retracement lines are used to identify support and resistance levels. Support levels area price levels where asset prices do not fall below over a period of time due to a convergence of demand. Conversely, resistance levels are price levels where an uptrend in prices faces resistance. The Fibonacci Retracement lines reflect possible support and resistance levels which can be used to identify points of entry and exit for a trade.
When the price of a cryptocurrency approaches the retracement lines, there is a possibility that the price of a cryptocurrency will either bounce off the line or cross the line to reach the next support or resistance level.
The Relative Strength Indicator (“RSI”) is used as a momentum indicator which measures the magnitude of recent price changes.
The RSI is determined with a 2-step calculation:
The RSI is generally measured over a 14-period timeframe (it could be 14 hours, days or months depending on what your time period of interest is). Through the formula above, we can see that RSI will rise as the number and size of positive gains increase and decrease when losses increase. The RSI is calculated on a scale of 0 to 100 and is usually shown as a line graph on charting applications.
Technical analysis is undeniably an important tool for traders. However, it is important to bear in mind that it is a statistic-based analysis tool and is not to be taken as a sure fire way to predict price movements. While the technical indicators you have selected may indicate a certain price direction, there are certainly instances where the market moves in a direction different from that being suggested.
Therefore, before taking a position in the market, it is crucial to do your research thoroughly, and to take appropriate steps to mitigate risks. For completeness, fundamental analysis is commonly taken to be the other half of the trading equation. In the context of trading cryptocurrencies, it pertains to assessing and evaluating the intrinsic value of the relevant cryptocurrency as well as the value it provides to users.
Both technical and fundamental analysis can and should be used in tandem to provide a more holistic assessment of any cryptocurrency.
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