What is Technical Analysis (TA)?
Technical analysis (TA) is a branch of analysis that tries to predict future price developments based on previous price action and volume data. TA is widely applied to stocks and other assets in traditional financial markets
, but it is also an indispensable component in cryptocurrency
Unlike fundamental analysis (FA), which looks at multiple price factors belonging to an asset, TA focuses solely on historical price action. Thus, it is used as a tool to examine the price fluctuations and volume data of an asset. Many traders try to spot new trends and favourable trading opportunities with the help of TA.
How does technical analysis work?
The main rationale behind technical analysis is that fluctuations in the price of an asset are not random and generally develop in observable price trends. Simply put, there is an assumption that price developments can be explained and predicted.
To research prices and thus find favourable trading opportunities, traders use a variety of charting tools known as indicators. TA indicators can help traders spot existing trends and provide insightful information about trends that may emerge in the future. Since TA indicators are fallible and therefore cannot always provide error-free predictive insights, some traders use multiple indicators to lower the risk.
Commonly used TA indicators
There are a lot of different indicators and new ones are added every year, some are easy to use and some require a lot of understanding. Since many traders prefer to keep it simple, simple moving averages (SMA) are high on the list of commonly used indicators. The SMA is a line through the graph that is calculated by averaging the price over time. The exponential moving average (EMA) is a modified version of the SMA in which more recent prices weigh more heavily in the calculation, creating a different line.
Another popular indicator is the relative strength index (RSI), which ranks under a class of indicators called oscillators. The RSI is often shown below the chart, not across the chart, and can be used to determine whether an asset has been oversold or overbought in a given time. The RSI is also a line between the values 0 and 100.
The Bollinger Bands (BB) indicator is another type of oscillator that is widely used. The BB indicator consists of two sidelines that move around the moving average line. This indicator is also used to spot overbought or oversold market conditions. It also examines the volatility of the market.
In addition to the general and simple TA instruments, there are also indicators that depend on other indicators to generate data. For example, the Stochastic RSI is calculated by applying a mathematical formula to the normal RSI. Another popular example is the moving average convergence divergence (MACD) indicator. The MACD is generated by subtracting two EMAs to create the mainline (the MACD line). This line is used to create another EMA known as the signal line. This also creates a separate MACD histogram, which is calculated by taking the difference between the MACD line and the signal line.
While indicators are useful for identifying trends, they can also be used to provide insights for potential entry and exit points (buy or sell signals). These signals can arise when specific things are happening in an indicator's chart. For example, an RSI value of 70 or higher may indicate that the market is in overbought conditions. The same logic applies if the RSI reaches a value of 30 or lower, which is generally considered to signal an oversold market condition.
As discussed earlier, the trading signals provided by technical analysis are not always accurate and a significant amount of noise (false signals) is produced by TA indicators. This is of particular concern within the cryptocurrency markets, which are much smaller than the traditional markets and therefore more volatile.
Despite the criticisms and long-standing debate about which analysis is better, many believe the combination of TA and FA is the best choice. Where FA is mostly used for long-term investment strategies, TA can provide useful information about short-term market conditions, which can be useful for traders and investors (e.g. in determining good entry and exit points)