What Is Technical Analysis? Does It Work in Crypto?

What is technical analysis?

Technical analysis is a market research branch focusing on chart trends and price patterns. Instead of researching macroeconomic pressures, company earnings reports, or a cryptocurrency's max supply, a technical analyst only considers charts. 

Most market historians credit U.S.-based journalist Charles Dow with inventing the field of technical analysis. In the 19th century, Dow developed six core beliefs to help explain stock market behavior from a technical perspective. According to the traditional Dow Theory, price trends always move through one of the following four phases:

1. Accumulation: Relatively low prices in an overall uptrend where inside investors start buying shares.  
2. Public participation: Noticeable upward or downward price movement that accelerates as more traders enter or exit the market. 
3. Distribution: An asset hits a local peak and investors who profited during accumulation start selling shares, creating a downtrend.
4. Panic: A sharp move lowers when all assets are sold off. Typically, panic selling happens after a major news event and leads to a bear market. 

In addition to identifying price trends, the Dow Theory highlighted the impact of volume levels and breaking news on stock prices. Although the theory's insistence on transportation and industrial stocks doesn't reflect today's hi-tech economy, technical analysts still use many of its core tenets.

Today, technical analysis covers many techniques that analyze charts for visual patterns, key levels, and historical trends. Investors can use technical analysis, but short-term traders tend to benefit the most from these tools.

Essential assumptions of technical analysis

Although the Dow Theory laid out technical analysis’ six core tenets, most of today's strategies rest on three assumptions:

1. The market discounts itself: Pure technical traders believe an asset’s market price already reflects its fundamental value. This theory assumes all market participants have already considered factors such as a company's balance sheet, a cryptocurrency's legal status, or changes in a country's interest rates before investing. Under this assumption, technical traders focus on an asset's chart to examine how supply and demand affect daily price movement. 
2. Prices always move according to trends: Traders are most interested in the overall trajectory of an asset's price rather than the erratic minute-to-minute movements. Even if traders focus on making hourly or daily trades, they always pay attention to the dominant trend. They often refer to this rule as "The trend is your friend till the end." 
3. History repeats itself: Since technical traders spend the most time studying prior price movements, they need to believe in historical patterns and trends. They hope to predict price action by researching old chart data. 

Tools of technical analysis

Rather than reading economic reports, crypto whitepapers, or earnings calls, technical traders are most interested in bar graphs, candlestick charts, and oscillators. People who follow technical analysis leverage the following tools:

1. Price charts: These show an asset’s opening and closing prices. Technical traders use multiple timeframes when examining an asset's prices to determine when to buy or sell it. For instance, they can use a monthly or weekly chart to understand an asset's overall trend, and for in-depth analysis, they may look at short-term charts (daily or hourly) to see how the asset has been performing relative to the primary trend. It's also common for traders to draw lines on their price charts to define their strategy. 
2. Support and resistance: Support and resistance are key price levels where assets tend to bounce. Support levels are on the bottom, while resistance lines are at the top of an asset's price range. Technical analysts often use these levels when setting up their trades with one of two assumptions: Either the asset’s price will break through a support or resistance line, or it’ll obey these levels and trade within a range. 
3. Trendlines: Trendlines are similar to support and resistance levels, but they highlight the long-term trajectory of a stock. For example, if a stock keeps making higher lows on a monthly price chart, it's likely in an uptrend. Conversely, stocks that continue to make lower highs on long-term charts are probably in decline. 

Indicators in technical analysis

Beyond the basics of price charts and support lines, technical analysts use many specialized stock and cryptocurrency indicators to plot their price predictions.  

1. Volume bars: Volume measures how much an asset swaps hands during a trading session. The higher the volume, the more activity there is in the market for that asset. Typically, the asset's price will be more volatile when volume accelerates.
2. Moving averages: Moving average lines track an asset’s median price in a given period. For example, the 200-day moving average for a stock plots the average price over the past 200 days. These lines can serve as trendlines and often reveal whether an asset is in a bearish or bullish pattern. 
3. Fear and Greed Index: While not as scientific as other methods, the Fear and Greed Index has become a popular tool in stock and crypto trend analysis. CNNMoney (now CNN Business) created it using metrics such as 52-week averages and daily volatility to gauge stock market sentiment. Today, the website Alternative.me has a crypto-focused Fear and Greed Index that monitors crypto prices, Bitcoin dominance, and social media sentiment. 
4. Relative strength index (RSI): Located near the volume graph, the RSI monitors how fast an asset's price has moved relative to its supply. The higher the RSI is, the greater odds an asset is overvalued. On the contrary, low RSI scores typically indicate oversold conditions. 
5. Bollinger bands: First introduced in the 1980s, Bollinger bands use moving averages and standard deviations to create a volatility zone around an asset. Standard deviations are used in probability theory to determine the most likely scenarios using prior data. Asset prices tend to hug the center (or mean) price. The two outer Bollinger bands help traders see when prices may be overextended. 
6. Fibonacci retracement: Fibonacci retracement levels are percentages that some technical traders use to guess future price movements. These percentages include 23.6%, 38.2%, 61.8%, and 78.6%. Proponents argue that Fibonacci retracements have a mysterious correlation with the natural world (e.g., the symmetry of flower petals), including financial markets. 

How does technical analysis work in crypto?

Since crypto is more volatile than traditional assets, traders rely heavily on technical cryptocurrency indicators. Just like stocks don’t have a standard form of technical analysis, there’s no single method on how to analyze cryptocurrency. In most cases, a crypto trader uses tools such as the RSI, cryptocurrency chart analysis, and support and resistance lines to decide when to enter or exit a trade. Today, many centralized crypto exchanges (CEXs) and advanced trading platforms provide crypto investors with a wealth of technical indicators. 

What is fundamental analysis, and how is it different from technical analysis?

Instead of focusing on price charts, moving averages, and daily volume, fundamental analysis is most interested in an asset’s intrinsic value. In other words, fundamental analysis looks into a particular investment’s financial health and its economic advantages. 

For example, when a fundamental analyst looks at a stock, they’ll be most interested in the company's leadership, recent quarterly reports, and performance relative to competitors. Fundamental analysis also accounts for macroeconomic trends such as inflation, unemployment, and interest rates.

Wrapping up 

Since the 19th century, technical analysis has been closely associated with short-term traders. Although long-term investors can use these tools, they’re most beneficial for trading firms that need ways to manage market risk. Common technical indicators and patterns such as Bollinger bands, support and resistance lines, and moving averages can also help explain seemingly erratic price movements. 

Even with the most advanced technical analysis tools, it's difficult to predict the next move for digital assets such as Bitcoin. Many people interested in cryptocurrencies put off using these coins due to their volatility. At Worldcoin, we aim to address this by putting a share of our crypto in everyone’s hands and airdropping DAI stablecoins to anyone who downloads our app. Subscribe to our YouTube channel to learn more.