In the first part of ” How To Read Crypto Charts “, we told you about market cap, Japanese candlesticks, and relative strength index (RSI). We will continue to learn how to read crypto charts and increasing our understanding of technical analysis by focussing on:
- Trend lines
- Simple moving average
- Bollinger bands
- Moving average convergence divergence.
A big part of learning how to read crypto charts is understanding trend lines. Drawing trend lines helps us in identifying and confirming trends. So, what is the trend line? A trend line is a straight line which connects at least two price points and can extend into becoming a line of support or resistance.
There are two primary kinds of trending lines:
- Downward trending line
- Upward trending line
Downward Trending Lines
The red diagonal line that you see in the chart is the downward trending line. A downward trending line has a negative slope and is created by connecting the upper shadow of the red candlesticks. These are some characteristics that you should keep in mind:
- The trend line is created by connecting more than two of these high points.
- Each of these high points should be lower than the previous high point.
The downward trending line acts as a resistance level and shows a declining price combined with increasing supply. As long as the price remains below the trending line, it shows a bearish trend. A break above the downtrend line indicates that a change of trend could be imminent.
Upward Trending Lines
An upward trending line has a positive slope and is formed by connecting more than two points on the lower shadow of the green candles (low point). Each low point is higher than the previous low point. Upward trending line acts as support and indicates that the demand of the asset is increasing as the price rises.
A rising price combined with increasing demand is very bullish and shows a strong desire on the part of the buyers. The upward trending line acts as support and the price remains above the line. However, if the price breaks through the trending line then that’s a strong bearish indicator.
Multiple trending lines
Till now we have just seen singular trending lines on price charts. However, more often than not, we draw multiple trending lines, like this:
Like the BTC/USD chart before, there are two downward trending lines and three upward trending lines. The convergence of these lines can help us understand the behavior of the assets.
Validating trending lines
When you draw a trending line, it must go through at least 2 points of the upper or lower shadow of the candlestick. Your tending line will be stronger if it can go through more of these points.
It is not possible to draw trending line on every price chart, even through they are an important part of technical analysis. The general rule is that a trending line should go through two points and a third point should validate it. If it goes through more than three points then the trending line is considered extremely strong.
Spacing of Points
The spacing of points in an uptrend or a downtrend line should not be too far apart or too close together. Having points which are too close together or too far apart can both be problematic.
As you can see above, the trending line has three points and they are way too close together. Since these sessions are so close together, it is not possible to know if this is an actual trend or not. On the other hand, If the points are too far apart, then that can be a problem as well:
The problem with this is that the points are so far apart that it is impossible to know if the points have any relations to each other are or not. Ideally, we want points which are relatively well-spaced out. This makes sure that we have a trending line which is strong and true.
Angles in trending lines
The steepness of the trending line is also a very important factor. Check out the chart below:
So, we have an upwards trending line which is extremely steep. The problem with such a steep line that it decreases the validity of the strength or resistance level. Even if this line was made from moderately spaced points, a steep line would still translate to weak support and resistance. On the other side of the equation, we have flat angles:
Over here you have a trending line with a flat angle. This is again useless since you are not really gaining any functionality of a classical trending line. You are far better off drawing horizontal lines of support and resistance instead of going ahead with trending lines like these.
Advantages and Disadvantages
The biggest advantage of trending lines is that it is extremely simple, cheap, and fast. Given some historical data, a trend line can be quickly drawn to make some estimates about how the price will respond in the future.
The biggest disadvantage is that this isn’t the most accurate of approaches. It needs to be used in conjunction with other technical analysis tools to make a more accurate prediction.
Important chart patterns
So, let’s look at some of the most important chart patterns using trending lines.
#1 Flag Formation
This is one of the most common patterns that you will see. The idea is simple, there will first either be a strong bearish movement or a strong bullish movement, which is shown via a big red or a big green candlestick. Following this movement, you will notice a period of consolidation, which is highlighted by the green rectangle above.
During the consolidation period, the bears and bulls are basically fighting each other for control of the market. In the example above, the bulls are desperately trying to bring the market back up but the bears want to bring the market down even lower. Eventually, the bears take over and continue the downward momentum. This is termed a “bearish breakout.” If the case was opposite then this would have been a “bullish breakout.”
If you feel that the market is prime for a bearish breakout then its best to sell during the consolidation period. Otherwise, if you think that the market will do a bullish breakout then buy in during the consolidation period.
#2 Triangle Formation
This is another extremely popular pattern that you will come across repeatedly during technical analysis – the triangle formation. The idea is simple, a triangle is formed upon the intersection of:
- A descending trending line and an ascending trending line.
- A line of resistance/support with an ascending trending line.
- A line of resistance/support with a descending trending line.
A triangle formation depicts that a bullish or a bearish breakout is imminent from the triangle.
#3 Head and Shoulders
The “head and shoulders” pattern is one of the most famous reversal patterns in technical analysis. A reversal pattern means that it either indicates the end of an uptrend or an end of a downtrend. Ideally, the pattern looks like this:
So, how does it work?
- Shoulder 1: The market is going up, when it meets resistance and then goes down. This forms the first shoulder.
- Head : The market then meets support and goes up. This support line is called the “neckline.” The market then goes up, beat the former resistance level and hits a peak before crashing all the way down to the neckline again as the market tries to readjust.
- Shoulder 2 : The market goes up from the neckline and meets a resistance level which is lower than the head. Shoulder 1 and shoulder 2 will not be of the same height in an ideal scenario. The market then rallies down and breaks below the neckline.
Of course, a reverse of this exists as well:
Alright, so let’s see how it works in a real market scenario.
This is actually a more realistic version of how a head and shoulders pattern works. The blue downward trending line works like a neckline for this graph. The shoulder 1 reaches the neckline and meets resistance. The price then goes down all the way to the support which is the black downwards trending line.
The price then bounces off the support line and then gathers enough momentum to breach past the resistance at the neckline and reaches a new high. This is the head of the pattern. The market then goes down again and goes below the neckline.
The price picks up now and meets resistance at the neckline again before dropping back down.
Now, let’s checkout the reverse head and shoulders pattern.
So, what is happening here?
The price is falling down meets support at the neckline. Upon bouncing back, the price goes up. This forms the shoulder 1.
The price now meets resistance at the black trending line and then falls down. In fact, the downward momentum is so strong that it breaches past the support at the neckline and goes down even further. Now the bulls rally together, the price goes up and meets resistance at the black trending line. This forms the head.
The price now falls down from the resistance line (black trending line) and goes down till the neck line. This is where it bounces up from the support and goes up again. This forms shoulder 2.
#4 Cup and Handle
A cup and handle pattern looks like this:
As you can see, this is called a cup and handle because of the pretty obvious pattern. So, what’s happening here?
There is a price wave down, followed by a stabilizing period, followed by a rally of approximately equal size to the prior decline. It creates a U-shape or a cup. The price then moves sideways or drifts downward within a channel. It forms the handle. The handle may also take the form of a triangle.
So, what is the purpose of the cup and handle pattern?
- Reversal: If the price is going down, then the cup and handle pattern reverses the downtrend.
- Continuation : Continuation happens when the price is already going up and the cup and handle pattern occurs and continues the uptrend.
Check out the following chart:
The price forms a cup and then an ascending triangle which acts as a handle. From the handle, the price has a positive breakout.
The price forms a cup and then a descending flag pattern which acts as a handle. From the handle, the price goes up.
Simple Moving Averages
The next tool at your disposal is simple moving averages. So, what is a moving average? A moving average is calculated by averaging a number of past data points. Once plotted, these points will help identify the direction of the current trend. When plotted, the traders will have the ability to look at smoothed data rather than focus on disjointed, fluctuating data.
So what is a simple moving average?
As the name states, simple moving average (SMA) is the simplest form of a moving average. SMA is calculated by taking the arithmetic mean of a given set of values.
The Formula For SMA Is as follows:
SMA n = (A1 + A2 + A3+…+An)/n.
Over here, A refers to the closing prices of the asset and n the period over which it is calculated. So, suppose you have an asset and its price over the last ten days is as follows:
1, 5, 4, 2, 3, 7, 6, 8 , 9, 9
Its 10-simple moving average is as follows: (1+5+4+2+3+7+6+8+9+9)/10 = 5.4.
Now, if we want to calculate the 50-day simple moving average then we will take the average of the last 50 values of that particular asset.
So, why are we calling it a moving average?
An asset’s closing price changes every single day. So for our asset A, if the value in the last 11 days looks like this:
1, 5, 4, 2, 3, 7, 6, 8 , 9, 9, 11.
When you calculate the SMA 10, then we drop the first value and calculate the average of the latest ten values: (5+4+2+3+7+6+8+9+9+11)/10 = 6.4
We will plot all these points on the graph and plot the curve.
So, SMA 20 or the 20-day simple moving average of the Bitcoin daily chart looks like this:
The purple curve is the SMA 20 of this curve.
How does SMA work?
Here are some things to keep in mind about SMA:
- If the SMA is moving up, the trend is up. If the SMA is moving down, the trend is down. SMAs are extremely helpful to determine the direction of the trend. SMA 200 is commonly used to find long term trend, SMA 50 is used to find intermediate trend, and many traders use SMA 20 to find short term trend.
- The longer the time period, smoother the price data and technical indicators. However, this results in more lag between the SMA and the source.
Price and SMA cross path
Price crossing SMA curves is often used to trigger trading signals:
- When a price crosses over the SMA curve, it is a bullish sign.
- When the SMA curve crosses over the price, it is a bearish sign.
SMAs cross each other
SMA Crossing SMA is another common trading signal.
- When a short period SMA crosses above a long period SMA, it is a bullish sign.
- When a long period SMA crosses above a short period SMA, it is a bearish sign.
This is mainly because a short period SMA crossing over long period SMA shows that a short-term trend is taking over a long-term trend. One of the most powerful indicators is the crossing of SMA 200 and SMA 50 curves.
- SMA 50 crossing over SMA 200 is a very bullish sign and is called the “golden cross.”
- SMA 200 crossing over SMA 50 is a very bearish sign and is called the “death cross.”
During technical analysis, you need to check multiple SMA curves to make a more accurate prediction:
The BTC/USD daily chart above uses SMA 20, SMA 50, and SMA 200.
Bollinger Band is a technical analysis tool which is defined by a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) curve of the crypto’s price. The SMA time period can be adjusted according to the user’s preferences. If you are using the SMA 20 curve, then you will be using the 20-day Bollinger band. This technical analysis tool was developed by famous technical trader John Bollinger,
In the chart below, we have used the 20-day Bollinger band on the BTC/USD daily chart.
The different lines in the Bollinger Band
There are three lines that makes up the Bollinger Band:
- The simple moving average of the time period that you chose. This is the middle curve in the band above.
- The positive standard deviation which is the upper curve.
- The negative standard deviation which is the lower curve.
So, how do we calculate this? You already know how to create a simple moving average curve. Now, let’s look into standard deviation. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting and finance. A standard deviation calculates how much the current value of an asset deviates away from its average value.
How can Bollinger bands help you with trading?
Bollinger bands are extremely popular among traders for two very specific reasons:
Widening and Narrowing of the band
When the bands come close together, constricting the moving average, it is called a squeeze or narrowing of the band. This signifies that the market is losing its volatility. When the bands go further apart or widens, it shows that the market is increasing its volatility. The widening and narrowing of the band will give you a great indication as to whether a price is going to change or not.
Breakouts of prize
To understand how breakouts work and how the price and the band interact with each other, take a look at the chart above. There are three areas where we want you to focus on:
- The green square
- The red square
- The black square
The green square
The price goes up and the market becomes so bullish that it breaches past the upper curve of the bollinger band. This is a strongly bullish sign. Ideally, we want our asset to be above the SMA curve. If it breaches the upper band then that means that the market is extremely bullish.
Within the green square there are a couple of red candlesticks as well. These candlesticks are bearish in the nature but they are still trending above or near the upper curve.
The red square
Over here, the bears have taken over the market and the price plummets till it breaches the lower band. There is a green candlestick as well however, it is touching the lower band. This means that even though the session was bullish, the overall sentiment remains bearish.
The black square
This pretty the same as the green square. The market has been taken over by the buyers and now the price has breached the upper band before re-adjusting.
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD) is a momentum indicator which is extremely useful in letting us know whether an asset has bullish or bearish momentum. It shows the relationship between two exponential moving averages of an asset’s price.
NOTE: An exponential moving average (EMA) is a kind of moving average like the simple moving average. An exponentially weighted moving average reacts more significantly to recent price changes than a simple moving average (SMA), which applies an equal weight to all observations in the period.
Components of MACD
In the chart above, you will see three different components:
- The blue curve which is the 9-day exponential moving average (EMA 9). This is also called the signal line.
- The MACD curve which is the orange curve.
- The histogram, which is the difference in values between the EMA 9 and MACD.
How MACD works?
The conventional MACD is calculated by subtracting the EMA 26 from the EMA 12. The Formula for MACD is: MACD = EMA 12 – EMA 26.
- When the signal line crosses over the MACD, it is a buy signal. When MACD crosses over the singal line, it is a sell signal. The more the distance between the two EMAs, the bigger the size of the histogram.
- The size of the histogram helps us understand how strong the bearish or bullish momentum is.
- If the speed of the crossovers is fast, then it is understood to be overbought or oversold.
What does MACD tell you?
Crossovers of EMAs
In the chart above, this is a segment of the MACD chart:
When the MACD falls below the signal line, it is a bearish signal which indicates that it may be time to sell. Similarly, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum.
Size of the Histogram
In the graph above, you see histograms of differing sizes. A large histogram shows that the momentum is heavy either on the bearish side (red histograms) or on the bullish side (green histograms).
Rapid Rises or Falls
When the MACD rises or falls rapidly it is a signal that the asset is overbought or oversold and will soon return to normal levels. Eg. check this again:
So we have a rapid descent, followed by a rapid ascent, a rapid descent and then a long period of sustained ascent. This tells us that the bears and bulls have been trading shots until finally, the bulls were able to end up on top.
Bringing Everything Together
So, in part 1 and part 2, we have learnt several different kinds of indicators. Let’s bring everything together and read the latest BTC/USD daily chart through technical analysis.
Let’s look at what we have here.
- The market currently has resistance at $4,200. The second last session was extremely bearish in nature and the price went down until it found support at the upward trending line (black line).
- When you check the MACD indicator, the signal line is about to crossover and go below the MACD curve which means that further downtrend may be expected.
- The market is still trending above both the SMA 50 and SMA 20 curves which are both bullish indicators and is one the upper half of the Bollinger band.
Alright, so in conclusion:
- The BTC/USD daily chart is currently experiencing bullish sentiment.
- However, the MACD indicator shows us that bearish dominance may be around the horizon.
Over the last two parts, we have shown you how different technical analysis tools work. Remember one thing, most of these indicators are not that accurate when used in isolation. You will need to use all these in conjunction with each to get a more accurate result. Hopefully, this guide has helped you learn how to read crypto charts!