Technical analysis, the study of chart patterns, is a tool that traders can use to increase their lead over others.
It does this by keeping the trader on the right side of the trend and issuing warnings when the trend is about to reverse. There are many indicators and patterns that can do this job, but there is no one particular indicator that will work for all market conditions.
Hence, traders prefer to use a combination of indicators that are useful in both trending and sectoral markets. However, this does not mean that the trader should clutter every chart with all available indicators. In some cases, instead of helping the trader, using too many indicators will only hinder the decision-making process and create confusion.
As traders develop their chart reading skills, they tend to reduce the number of indicators and use those that better suit their trading style. Again, there are no perfect indicators that give better results than others. It’s just a matter of preference and practice.
This article discusses moving averages and the relative strength index as indicators. Without going too deeply into the technical details of each indicator, the basic ways in which they can be used effectively are highlighted. The methods discussed here are by no means exhaustive, there are myriad other options and traders can use those that work best for them. The explanation can be used as a guide to further improve analytical skills.
Moving averages are trend following, or are also known as lag indicators, as they provide lagging feedback after the price movement has already taken place. The most popular time frames for trading and investing are the 20, 50 and 200 period moving averages. Short-term traders also use the 5-period and 10-period moving averages, but they have a tendency to lash and may not be suitable for everyone.
There are four types of moving averages: simple, exponential, smoothed, and weighted, but the most popular are the simple and exponential moving averages.
When calculating, exponential moving averages are weighted more heavily on the most recent price data so that they usually react quickly to price changes. On the other hand, the price data is weighted equally by a simple moving average, which is why it usually reacts comparatively slowly to price changes.
Hence, traders tend to use EMA for the shorter time frames like 10 and 20 as they capture the changes quickly, and for the longer time frames the simple moving averages are used because trends usually don’t change direction quickly. The current example uses the 20-day EMA and the 50-day SMA.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum indicator that tracks price changes and acts as an oscillator that ranges from 0 to 100.
Typically, readings below 30 are viewed as oversold and above 70 as overbought. While these boundaries work well in a sectoral market, they tend to give the wrong signal during trending periods.
The most popular time frame used is a 14 period RSI. This is not set in stone, however, as short-term traders can use an RSI with 5 or 7 periods, while long-term investors can opt for an RSI with 21 or even 30 periods.
One of the most popular uses for the RSI is to detect divergence, which warns traders of a possible trend reversal. After the basics, let’s look at some methods to use the indicators for analysis.
The first thing a trader should learn is to spot a trend. Trading in the direction of the trend is worthwhile as an established trend offers multiple profitable trades. Let’s understand this with a crypto price promotion.
Examples of a sector-specific market
In a tiered market, the moving averages cross each other and do not fall up or down over an extended period of time. Look at the area enclosed by the ellipse in the table above where Bitcoin (BTC) remained tied to range and the moving averages were flattened. Such markets tend to have no direction and are difficult to forecast and trade.
As shown in the graph above, the price of Polkadot (DOT) got stuck in a range and the moving averages were flat with no sense of direction. When the price is broadly between two boundaries, the market is said to be sectoral.
Next, let’s try to identify a trending market as this is where the most lucrative trading opportunities arise.
Recognize upward trend
Bitcoin was largely stuck in one area from August 1, 2020 to October 20, 2020. During this period the moving averages were flat with no direction.
However, on October 21, 2020, the price broke above the range and the RSI also jumped into the overbought territory. At the start of a new trend, the RSI generally remains overbought in the early stages of the trend, and this can be seen here as well.
As the price rose, the 20-day EMA appeared first, followed by the 50-day SMA. When a trend starts, it usually stays in place for an extended period of time. Let’s look at another example of a trend.
After staying in an area from September 6, 2020 through December 27, 2020, DOT broke out of the area on December 28, 2020. The RSI also rose to overbought levels above 70 and the moving averages began to rise. Notice again how quickly the 20-day EMA rose while the 50-day SMA took time to catch up.
In the above case, the RSI did not stay overbought for an extended period of time, but stayed above 50, indicating that a rule does not fit everywhere.
Identifying a downtrend
Unlike uptrends, which take time to form and stay in place for an extended period of time, downtrends are violent and, similar to the 2018 crypto bear market, can stretch for a long period of time or quickly reverse direction after a sharp decline .
The above diagram contains two important things for the trader to keep in mind. First, the RSI had hit lower peaks since late February, even though the price had continued to rise. This is a classic sign of a possible trend reversal. Again, this isn’t foolproof, but when traders combine the signal with the price movement the chance of avoiding disaster is high.
The negative divergence in the RSI gained momentum as the moving averages made a bearish transition as the 20-day EMA, which had stayed above the 50-day SMA for the past few months, broke below the 50-day SMA . This was a sign that short-term price action was weakening and that the trend could potentially be reversed.
After staying in one range for a few days, Bitcoin collapsed on May 12 and the moving averages began to decline. This, along with the RSI in negative territory, was a signal to traders that the trend was reversing. As long as the price stays below the moving averages and both the 20-day EMA and 50-day SMA continue to decline, the trend will remain bearish.
In the graph above we can see that after the uptrend, DOT was stuck in an area where the moving averages flattened and crossed. Difficult to call this the top as the price could have gone either way. However, when the trader also looked at the RSI, he showed a negative divergence and warned of a possible reversal.
The sharp fall on May 19th confirmed the downtrend as both moving averages decreased and the RSI was in the negative zone.
Remember, no signal is absolute!
For most new traders, the moving averages and RSI are essentially the starting point for identifying trends.
Investors dipping their toes into the trade should definitely practice identifying the main trend as it could keep them from going against the market and getting burned. The following articles discuss entry and exit strategies using the indicators.
The views and opinions expressed are those of the author only and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading step is associated with risks. You should do your own research when making a decision.