Many investors evaluate opportunities with fundamental analysis. For instance, they may calculate a public company's intrinsic value by looking at its revenue, net income and the valuation of its peer group. Then, they can compare the intrinsic value to the current market price to see whether the investment is overvalued or undervalued.
Cryptocurrencies have no intrinsic value since it's designed to be a medium for exchange. Rather, the day-to-day value of a cryptocurrency is a function of supply and demand at any given moment. If demand for a cryptocurrency rises, the price increases until mining activity increases enough to equalize the market with greater supply.
Let's take a look at how to analyze these supply and demand economics using technical analysis, as well as create an effective strategy.
What is Technical Analysis?
Technical analysis leverages statistical analysis and behavioral economics to analyze prices. For example, a moving average shows traders where the price of a cryptocurrency is relative to a longer-term average. The mean-reversion theory suggests that prices eventually return to these historical averages, so moving averages may tell traders if an asset is overvalued.
There are a few different types of technical analyses:
- Technical Indicators are statistical calculations designed to analyze price behavior. Many technical indicators are plotted on a stock chart alongside the price, but oscillators are plotted on a sub chart to show changes in momentum. Popular examples of technical indicators include the moving average convergence-divergence (MACD) and the relative strength index (RSI).
- Chart Patterns and Trend Lines are lines drawn on a price chart that provide insights into the underlying psychology of the market. The most important are support and resistance trend lines that show areas of historical price impact, but there are also established patterns like the Head and Shoulders or Double Top patterns.
- Chart Types show prices in different formats to make them easier to interpret. Candlestick charts are the most popular chart type since they show the open, high, low and closing prices for a given period in an easy-to-interpret way. In fact, there are several different types of candlestick patterns that signal different market dynamics.
Most cryptocurrency trading platforms include built-in technical analysis capabilities. For example, Coinbase Pro provides a wide range of charting tools designed to simplify the technical analysis process. There are also third-party analytical platforms that provide charts without any trading capabilities, such as TradingView.
Common Technical Analysis Strategies
Technical analysis strategies are helpful for identifying overbought or oversold conditions, but they can also be used to generate actual trading signals. For instance, a price that breaks down from a key trend line could be interpreted as a sell signal. Many traders look at more than one form of technical analysis to confirm a trading signal's accuracy.
For example, the moving average crossover is a simple technical analysis strategy whereby a trader looks for two moving averages to cross paths. A short-term moving average (such as a 50-day moving average) crossing above a long-term moving average (such as a 200-day moving average) is a bullish sign that the price could trend higher in the future.
Let's take a look at an example of Bitcoin:
In this chart, the 50-day moving average crossed above the 200-day moving average in late-April, signaling the beginning of a new uptrend. The relative strength index (RSI) suggested that the price was overbought at several points before an actual reversal occurred, while the trend lines helped predict areas where the price reacted either higher or lower.
Many advanced traders develop trading systems based on technical analysis. For instance, they may create a buy rule whenever a moving average crossover occurs that will automatically trigger an actual trade. These traders can focus more on building a robust trading system with effective rules rather than the day-to-day execution of trades.
Considerations for Active Traders
Technical analysis helps active traders make more informed trade decisions, but there are many other challenges to overcome in order to be successful. For example, traders must ensure that they work with exchanges that charge reasonable fees, have ample liquidity, and provide the tools they need to effectively leverage technical analysis to their advantage.
Coinbase Pro and other advanced crypto exchanges support most common technical analysis, including indicators and chart patterns. Advanced traders looking for automation may need to look towards platforms that augment these capabilities, such as QuantConnect or CryptoHopper. These tools make it easy to build and maintain automated trading systems.Traders must also keep careful track of their transactions for tax season.
ZenLedger makes it easy to track every transaction across multiple exchanges and accurate calculate their cost basis. Using this information, the tool automatically fills out common IRS forms, such as Form 8949 and Form 1040 Schedule D, as well as other regulatory paperwork.
In addition to avoiding potential audits, proper tracking ensures that you can claim any capital losses to offset other income, which can lessen the blow of a bad year.
The Bottom Line
Technical analysis plays an important role in the cryptocurrency markets since there's little intrinsic value to analyze prices. Using statistical analysis and behavioral economics, technical analysis attempts to provide insights into real-time supply and demand conditions, as well as predict future price action based on those factors.
The best way to get up-to-speed with technical analysis is by reading some of the many books written on the topic or by taking online courses. Along the way, it’s helpful to practice technical analysis in real-time by paper trading and/or backtest trading systems based on technical analysis to confirm their accuracy over time.
In the meantime, to ensure that all of your crypto traders are properly recorded and easily available to your accountant or any auditors.