Do you want to know how to read cryptocurrency charts? Do you want to do technical analysis on Bitcoin or figure out the price patterns of Ethereum? Or do you want to separate the astrology from what’s back by statistical evidence? Read on to find out the answer to all these questions!
This article first covers common technical analysis techniques. Then we cover evidence behind the techniques, and finally converge on the top technique that works for us.
Classical Technical Analysis
Classically, technical analysis covers Dow Theory, Time Frames, and Reversal Patterns. Read this section if you want to learn more, but feel free to skip down to “what works?”
On aspect of classical technical anaylsis is Dow Theory. Originally developed for stocks, Dow theory also works for cryptocurrencies. Throughout this article, I’ll use Bitcoin, but the theory works just as well for other cryptocurrencies other than when specified.
- Generally, the current price of Bitcoin already accounts for fundamentals. Bitcoin prices already transaction volume, exchange, volume, regulations, etc. Another way to say this is that Bitcoin prices are mostly efficient in the semi-strong sense.
- While Bitcoin prices are like a random walk, it is not exactly a random walk. The deviation from Bitcoin prices from a random walk is what creates trading opportunities.
The major tenants of Dow theory are then:
- There are three main movements of the market. You can think of this as timespans of movement.
- The “main movement” is the long term 3-12 month trend for Bitcoin. Usually this is either bullish (going up) or bearish (going down). Bullish markets are generally better to be in than.
- There is a medium swing. For Bitcoin, we have found this generally lasts from 3 days to 3 months. We have found it better to buy in an up medium swing and sell in a down medium swing.
- Finally, there is a short swing or “minor movement“. We’ve usually seen this last below 10 hours. Our general finding is that for Bitcoin, it is good to be against this swing. That is to say, if there is a large spike upwards in Bitcoin, you should sell Bitcoin between 1-10 hours after this swing. [TKTKT graph reconciliation]
- There are three phases of the market
- During the Accumulation, the smart money is starting to buy (or sell) Bitcoin. They know that the price is about increase, and slowly buy up coins. Because the smart money by definition is a minority, prices don’t move very much.
- During the Absorption phase, the public realizes that Bitcoin is worth a lot more now. This is when the public start buying and the price increases at a rapid pace.
- During the Distribution phase, the smart money starts selling because their thesis has fully played out. Prices fall a bit and
Does technical analysis and chart reading work?
After understanding all these patterns, you might be asking yourself, do the techniques above work for sure, or most of the time? Or are they in the same category as astrology and horoscopes, where people convince themselves via confirmation bias that they work?
Evidence For: Popularity and Rigorous Papers
The evidence is mixed. The most respected academic paper reviewing technical analysis [link tk] reports that when subject to rigorous analysis, the vast majority of technical trading signals fall a part. This is due in part to a theory call weak-form efficiency of the market, which holds for the most part.
Evidence Against: Efficient Market Theory
This theory says that past price history of a stock (or any tradable symbol) should contain no predictive power for the future, which would rule out technical analysis and charting. For the most part, the market is weak-form efficient, but there are clear exceptions. For example, the paper above shows that 10 popular technical trading strategies work very well when automatically programmed to trade for the stock market before year 2000.
The Simplest Technical Analysis / Chart Reading With Strongest Evidence
What is autocorrelation?
One technical analysis theory that works very well is autocorrelation analysis. Autocorrelation is simply whether after a previous up move, Bitcoin (or any symbol) tends continue going up (momentum) or tends to reverse or go down (reversion or value).
Well-tested autocorrelation strategies is acknowledged to work even amongst some of the more die-hard efficient market economicsts. Hedge funds [tk] with hundreds of billions of dollars under management trade on this technical analysis.
The basis of autocorrelation analysis is simple. Unlike more complex technical anaylsis theories, there are few degrees of freedom, and fewer ways for the strategy to go wrong. To test an autocorrelation theory, you can just
Testing Autocorrelation with the Variance Ratio
- Compute the autocorrelation of a symbol (like Bitcoin) over various time intervals, like 1 minute, 1 day, 1 month, or 1 year.
- Inspect the autocorrelation over different time periods, and conduct a statistical test to ensure it doesn’t arise due to random chance.
We do this test for you, and then tell you how to trade on it.
Results of the Variance Test
The autocorrelation chart for Bitcoin is as follows.
You can see that there is a lot of reversion on the short time horizon up to 12 hours. This means a sharp up move in Bitcoin in an hour will tend to slightly revert up to the 12 hour mark.
However, from 12 hour to 3 months, there is a lot of momentum. This means that if Bitcoin has risen a ton over the last 12 hours, or last 24 hours, this will tend to continue for many days and weeks.
This tendency is only slight, so don’t treat it like a sure thing.
How to Trade Autocorrelation
Trading the Short Term Reversion
How to trade on this depends on whether you are short term or long term.
If you can trade on the order of hours, you want to look mostly for the reversion patterns. Jump in after a large up or down move (usually one that is a 1-in-10 day thing). Revert the trade, and get out by the 24 hour mark. This strategy will generally work, but you should get out by 24 hours even if it doesn’t work yet.
Trading the Long Term Momentum
If you trade daily or less frequently (up to 1-2 weeks, but I wouldn’t do this if you can only trade once every couple of months or year), you would want to do the momentum trade. The momentum trade is basically buying after a 1-in-10 up day. Then buy and hold for the next few weeks, and generally you’ll make money.