The legendary hedge fund manager Bruce Kovner thinks of technical analysis as a thermometer. He said:
“Fundamentalists who say they are not going to pay attention to the charts are like a doctor who says he’s not going to take a patient’s temperature. But, of course, that would be sheer folly. If you are a responsible participant in the market, you always want to know where the market is — whether it is hot and excitable, or cold and stagnant. You want to know everything you can about the market to give you an edge.”
Charts are the 2-dimensional representation of supply and demand in real-time. Technical indicators are a derivative of the price and volume. Understanding how to read these technicals is critical not just for spotting opportunities but for managing risk. And there is perhaps no market that lends itself better to technical analysis, than bitcoin.
This is because the crypto space is predominately comprised of younger retail traders and their unrefined sentiment shows up in fairly predictable chart patterns time and time again. In this article, we’re going to show you the three things you need to know to analyze and trade bitcoin like a professional. Here goes…
- Identify the trend, it is your friend…
As Market Wizard Ed Seykota put it “The trend is your friend until it bends”. All profitable trading can be simplified down to finding and riding trends. Here’s a simple and very effective way to identify the trend direction in bitcoin.
The directional slope of the Bollinger Band midline (20, 2). The Bollinger Band is a classic indicator that is an envelope plotted at a standard deviation level above and below a simple moving average of the price. The standard inputs are a simple 20-day moving average and 2stdev. This indicator is available on any charting service.
The 20-day moving average is the middle line of the Bands. When trading bitcoin, you almost always want to be trading in the slope direction of that middle line. That’s the direction of the trend, which is your friend, remember?
Look at this chart below. The midline moving average identifies the direction of the trend. We want to be buying when it’s pointing up, selling when it’s pointing down, and doing nothing when it’s sideways. Easy, right?
- Understand mean-reversion to time entries and exits…
Two forces are at work on price at all-times. These are (1) trends and (2) mean reversion or counter-trend. Put together, markets (including bitcoin) tend to form fractal sine curves throughout various timescales.
You now know how to identify the first force, which is the trend. Here’s how to identify the second, mean reversion. And lucky for us, we get to use the same indicator, Bollinger Bands.
Bolling Bands are really the perfect tool for this because they measure the price’s standard deviation from its trend or moving average. And since price action moves in waves or sine curves, it tends to hit its upper or lower band and then revert.
As a result, using Bollinger Bands can greatly help us time our entries and exits once we’ve identified a trend. In an uptrend, we want to be buying when the price comes down to the midline or even lower Bollinger band. And we want to be taking profits when the price goes above its upper band and vice-versa for when it’s in a downtrend.
- How to spot the start of explosive trends…
Markets are like a rubber band. The most explosive trends follow periods of compressed volatility (ie, tight low volatility sideways regimes) where the rubber band is wound uptight. Conversely, major tops, and bottoms occur when volatility is high.
So when looking for explosive trends we want to identify extended periods of compression, since compression precedes expansion (large trends). There are a number of tools to do this but in keeping with our simplicity today, we’re going to use Bollinger Band % width. This is another classic indicator that just measures the percentage gap between the upper and lower Bollinger Band over time.
We can see on the chart below that when the BB% width collapses, indicating low volatility and high compression, a large move shortly follows. You can see this time and time again throughout Bitcoin’s trading history. This is why Bitcoin is one of the best technical markets to trade.
And the periods of high volatility — a large % BB width — marked major bottoms and tops.
This game is hard enough. Too many people for some reason or another go and make it a lot tougher. In today’s article, we showed you how to identify the direction of the trend, how to time your entries and exits to put mean reversion in your favor, and how to spot periods of major compression, and why these compression zones tend to precede explosive trends.
And we did all of this by only using two technical indicators that are directly related. Simplification is paramount in this game because there’s noise enough in markets. Ultimately, your ability to effectively use these tools and pull money from the bitcoin, or any other financial market, will come down to your own ability to manage your psychology and efficiently implement a sound strategy like the one we showed you here today.
That is how you use technical analysis to trade Bitcoin.