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Investors can use two types of analysis to evaluate a crypto opportunity: fundamental and technical. Fundamental analysis involves researching various aspects of a Web3 project, such as the utility of its native token. Technical analysis, on the other hand, analyses an asset’s trading history in an attempt to predict how its price might move in the future.
This third and final article in the series marking crypto’s resurgence highlights three of the most popular technical analysis tools. It also covers risk management strategies, which are vital to implement regardless of the analytical approach employed by investors.
Technical Analysis Tools
Investors can choose from a range of technical analysis tools, so here’s a brief overview of three that are both popular and relatively easy to put into practice.
Moving Averages
Moving averages (MA) identify the direction of a trend. If the line is rising, an asset is on an uptrend, while a falling MA indicates a downtrend. A simple MA (SMA) is calculated by averaging a value, typically an asset’s opening or closing price, over a given amount of time. For instance, a 50-day SMA finds the average of the closing price from the last 50 days. An exponential MA weighs recent prices higher, so it responds quicker to fluctuations.
Investors can view MAs over different timeframes. Shorter periods like 50 days and below are more effective in the immediate term because they closely track price action, as demonstrated in the chart above. Investors who buy and hold tend to use longer periods, such as 100 days. That said, combining short and long-term MAs can identify a change in an asset’s trajectory. A short-term MA crossing above a long-term MA suggests that an asset is about to rally, so it’s known as a bullish crossover. The reverse effect is a bearish crossover.
Support and Resistance
At some point, when an asset is in a downtrend, the price can become attractive, so investors start buying again. This level is called support. Resistance is the opposite- eventually an asset’s price rises too high, so investors stop buying it.
Support and resistance can provide entry points for an investment because the asset responds in one of two ways when it reaches these levels- it rebounds and starts moving in the other direction, or it breaks through and keeps going until it arrives at the next point of support or resistance. Breaking through suggests the current trend is relatively strong, whereas rebounding indicates a reversal.
Like MAs, investors can choose their preferred timeframe. Longer periods generally present a stronger indicator because price tests those levels more frequently. But support and resistance aren’t failsafe- prices sometimes cross over briefly before quickly reversing.
Trading Volume
Trading volume measures how much of an asset has traded in a given period. CoinMarketCap, one of the leading providers of price data for the crypto markets, shows that $35.6 billion worth of bitcoin has changed hands in the last 24 hours (as of April 12, 2024).
While MAs identify a trend, investors can use trading volume to measure its strength. A rising market accompanied by increasing volume indicates a strong rally, whereas weak volume suggests that a reversal could occur more easily.
Another way to analyse the impact volume has on price is to monitor the inflows into products offering exposure to it, such as exchange-traded products (ETPs). For bitcoin, investors can access this data from CoinShares’ weekly Digital Assets Fund Flows report.
Risk Management Strategies
While these tools can help to indicate a trend’s direction and the strength of a bull or bear market, investors must implement risk management strategies to protect their capital.
Stop-loss Orders
Stop losses limit potential losses if the market moves in the wrong direction. When trading on an exchange, investors can place a stop loss order, which means the exchange automatically closes the position by buying or selling the asset if it hits a set price. For instance, bitcoin was trading at $70,000 on April 12, 2024. Say an investor expected it to rise and went long with a stop loss placed at $63,000. If bitcoin fell, the exchange would close the position, ensuring the investor suffered a maximum loss of 10%.
Position Sizing
Position sizing refers to the number of units an investor buys in an asset, like shares in a crypto ETP. The first step in calculating position size is determining what percentage of overall capital to put at risk. Say an investor has $50,000, 2% would mean risking $1,000. The next step is to work out the difference between the market price of the share and the stop loss. So if the share trades at $100 and the investor places the stop loss at $80, the difference is $20. Finally, divide the capital at risk by the risk per unit. In the example above, this would lead to purchasing 50 shares ($1,000 divided by $20).
Diversification
Diversification is a key risk manager strategy that involves building a portfolio from different assets, such as shares, bonds and crypto, along with assets from different industries or sectors and countries or regions. The theory is that if one type of investment or security underperforms, it shouldn’t disproportionately impact the portfolio’s overall returns. Investors seeking access to ready-made diversified products may consider the CoinShares Physical Top 10 Crypto Market ETP and the CoinShares Physical Smart Contract Platform ETP, which track the performance of indices consisting of the biggest cryptocurrencies by market capitalisation and providers of the crypto infrastructure layer respectively.
Conclusion
Technical analysis is an approach to researching investment opportunities that involves analysing an asset’s price. Three of the most popular tools are moving averages, support and resistance, and trading volume. Moving averages calculate average price over a given period, support and resistance identify potential turning points when an asset becomes oversold or overbought, and trading volume measures how much an asset has traded over a certain timeframe.
Investors can also implement risk management strategies based on an asset’s price, such as calculating position size and placing a stop loss order. Building a diversified portfolio is an effective strategy regardless of whether an investor employs technical or fundamental analysis.