Technical Analysis (TA) Basics
While the basic concepts of technical analysis are relatively easy to grasp, it’s a difficult art to master. Becoming consistently good at trading is a process that takes time. It requires a lot of practice in refining your trading strategies and learning how to formulate your own trade ideas. This way, you can find your strengths, identify your weaknesses, and be in control of your investment and trading decisions. This article will introduce you to some technical analysis basics in addition to some of the most common mistakes.
What is a long position?
A long position (or simply long) means buying an asset with the expectation that its value will rise. Long positions are often used in the context of derivatives products or Forex, but they apply to basically any asset class or market type. Buying an asset on the spot market in the hopes that its price will increase also constitutes a long position.
Going long on a financial product is the most common way of investing, especially for those just starting out. Long-term trading strategies like buy and hold are based on the assumption that the underlying asset will increase in value. In this sense, buy and hold is simply going long for an extended period of time.
However, being long doesn’t necessarily mean that the trader expects to gain from an upward movement in price. Take leveraged tokens, for example. BTCDOWN is inversely correlated to the price of Bitcoin. If the price of Bitcoin goes up, the price of BTCDOWN goes down. If the price of Bitcoin goes down, the price of BTCDOWN goes up. In this sense, entering a long position in BTCDOWN equals a downward movement in the price of Bitcoin.
What is shorting?
A short position (or short) means selling an asset with the intention of rebuying it later at a lower price. Shorting is closely related to margin trading, as it may happen with borrowed assets. However, it’s also widely used in the derivatives market, and can be done with a simple spot position. So, how does shorting work?
When it comes to shorting on the spot markets, it’s quite simple. Let’s say you already have Bitcoin and you expect the price to go down. You sell your BTC for USD, as you plan to rebuy it later at a lower price. In this case, you’re essentially entering a short position on Bitcoin since you’re selling high to rebuy lower. Easy enough. But what about shorting with borrowed funds? Let’s see how that works.
You borrow an asset that you think will decrease in value – for example, a stock or a cryptocurrency. You immediately sell it. If the trade goes your way and the asset price decreases, you buy back the same amount of the asset that you’ve borrowed. You repay the assets that you’ve borrowed (along with interest) and profit from the difference between the price you initially sold and the price you rebought.
So, what does shorting Bitcoin look like with borrowed funds? Let’s look at an example. We put up the required collateral to borrow 1 BTC, then immediately sell it for $10,000. Now we’ve got $10,000. Let’s say the price goes down to $8,000. We buy 1 BTC and repay our debt of 1 BTC along with interest. Since we initially sold Bitcoin for $10,000 and now rebought at $8,000, our profit is $2,000 (minus the interest payment and trading fees).
What is the order book?
The order book is a collection of the currently open orders for an asset, organized by price. When you post an order that isn’t filled immediately, it gets added to the order book. It will sit there until it gets filled by another order or canceled.
Order books will differ with each platform, but generally, they’ll contain roughly the same information. You’ll see the number of orders at specific price levels.
When it comes to crypto exchanges and online trading, orders in the order book are matched by a system called the matching engine. This system is what ensures that trades are executed – you could think of it as the brain of the exchange. This system, along with the order book, is core to the concept of electronic exchange.
What is the order book depth?
The order book depth (or market depth) refers to a visualization of the currently open orders in the order book. It usually puts buy orders on one side, and sell orders on the other and displays them cumulatively on a chart.
Order book depth of the BTC/USDT market pair on Binance.
In more general terms, the depth of the order book may also refer to the amount of liquidity that the order book can absorb. The “deeper” the market is, the more liquidity there is in the order book. In this sense, a market with more liquidity can absorb larger orders without a considerable effect on the price. However, if the market is illiquid, large orders may have a significant impact on the price.
What is a market order?
A market order is an order to buy or sell at the best currently available market price. It’s basically the fastest way to get in or out of a market.
When you’re setting a market order, you’re basically saying: “I’d like to execute this order right now at the best price I can get.”
Your market order will keep filling orders from the order book until the entire order is fully filled. This is why large traders (or whales) can have a significant impact on the price when they use market orders. A large market order can effectively siphon liquidity from the order book. How so? Let’s go through it when discussing slippage.
What is slippage in trading?
There is something you need to be aware of when it comes to market orders – slippage. When we say that market orders fill at the best available price, that means that they keep filling orders from the order book until the entire order is executed.
However, what if there isn’t enough liquidity around the desired price to fill a large market order? There could be a big difference between the price that you expect your order to fill and the price that it fills at. This difference is called slippage.
Let’s say you’d like to open a long position worth 10 BTC in an altcoin. However, this altcoin has a relatively small market cap and is being traded on a low-liquidity market. If you use a market order, it will keep filling orders from the order book until the entire 10 BTC order is filled. On a liquid market, you would be able to fill your 10 BTC order without impacting the price significantly. But, in this case, the lack of liquidity means that there may not be enough sell orders in the order book for the current price range.
So, by the time the entire 10 BTC order is filled, you may find out that the average price paid was much higher than expected. In other words, the lack of sell orders caused your market order to move up the order book, matching orders that were significantly more expensive than the initial price.
Be aware of slippage when trading altcoins, as some trading pairs may not have enough liquidity to fill your market orders.
What is a limit order?
A limit order is an order to buy or sell an asset at a specific price or better. This price is called the limit price. Limit buy orders will execute at the limit price or lower, while limit sell orders will execute at the limit price or higher.
When you’re setting a limit order, you’re basically saying: “I’d like to execute this order at this specific price or better, but never worse.”
Using a limit order allows you to have more control over your entry or exit for a given market. In fact, it guarantees that your order will never fill at a worse price than your desired price. However, that also comes with a downside. The market may never reach your price, leaving your order unfilled. In many cases, this can mean losing out on a potential trade opportunity.
Deciding when to use a limit order or market order can vary with each trader. Some traders may use only one or the other, while other traders will use both – depending on the circumstances. The important thing is to understand how they work so you can decide for yourself.
What is a stop-loss order?
Now that we know what market and limit orders are, let’s talk about stop-loss orders. A stop-loss order is a type of limit or market order that’s only activated when a certain price is reached. This price is called the stop price.
The purpose of a stop-loss order is mainly to limit losses. Every trade needs to have an invalidation point, which is a price level that you should define in advance. This is the level where you say that your initial idea was wrong, meaning that you should exit the market to prevent further losses. So, the invalidation point is where you would typically put your stop-loss order.
How does a stop-loss order work? As we’ve mentioned, the stop-loss can be both a limit or a market order. This is why these variants may also be referred to as stop-limit and stop-market orders. The key thing to understand is that the stop-loss only activates when a certain price is reached (the stop price). When the stop price is reached, it activates either a market or a limit order. You basically set the stop price as the trigger for your market or limit order.
However, there is one thing you should keep in mind. We know that limit orders only fill at the limit price or better, but never worse. If you’re using a stop-limit order as your stop-loss and the market crashes violently, it may instantly move away from your limit price, leaving your order unfilled. In other words, the stop price would trigger your stop-limit order, but the limit order would remain unfilled due to the sharp price drop. This is why stop-market orders are considered safer than stop-limit orders. They ensure that even under extreme market conditions, you’ll be guaranteed to exit the market once your invalidation point is reached.
What are makers and takers?
You become a maker when you place an order that doesn’t immediately get filled but gets added to the order book. Since your order is adding liquidity to the order book, you’re a “maker” of liquidity.
Limit orders will typically execute as maker orders, but not in all cases. For example, let’s say you place a limit buy order with a limit price that’s considerably higher than the current market price. Since you’re saying your order can execute at the limit price or better, your order will execute against the market price (as it’s lower than your limit price).
You become a taker when you place an order that gets immediately filled. Your order doesn’t get added to the order book, but is immediately matched with an existing order in the order book. Since you’re taking liquidity from the order book, you’re a taker. Market orders will always be taker orders, as you’re executing your order at the best currently available market price.
Some exchanges adopt a multi-tier fee model to incentivize traders to provide liquidity. After all, it’s in their interest to attract high volume traders to their exchange – liquidity attracts more liquidity. In such systems, makers tend to pay lower fees than takers, since they’re the ones adding liquidity to the exchange. In some cases, they may even offer fee rebates to makers.
What is the bid-ask spread?
The bid-ask spread is the difference between the highest buy order (bid) and the lowest sell order (ask) for a given market. It’s essentially the gap between the highest price where a seller is willing to sell and the lowest price where a buyer is willing to buy.
The bid-ask spread is a way to measure a market’s liquidity. The smaller the bid-ask spread is, the more liquid the market is. The bid-ask spread can also be considered as a measure of supply and demand for a given asset. In this sense, the supply is represented by the ask side while the demand by the bid side.
When you’re placing a market buy order, it will fill at the lowest available ask price. Conversely, when you place a market sell order, it will fill at the highest available bid.
What is a candlestick chart?
A candlestick chart is a graphical representation of the price of an asset for a given timeframe. It’s made up of candlesticks, each representing the same amount of time. For example, a 1-hour chart shows candlesticks that each represent a period of one hour. A 1-day chart shows candlesticks that each represent a period of one day, and so on.
Daily chart of Bitcoin. Each candlestick represents one day of trading.
A candlestick is made up of four data points: the Open, High, Low, and Close (also referred to as the OHLC values). The Open and Close are the first and last recorded price for the given timeframe, while the Low and High are the lowest and highest recorded price, respectively.
Candlestick charts are one of the most important tools for analyzing financial data. Candlesticks date back to the 17th century Japan but have been refined in the early 20th century by trading pioneers such as Charles Dow.
What is a candlestick chart pattern?
Technical analysis is largely based on the assumption that previous price movements may indicate future price action. So, how can candlesticks be useful in this context? The idea is to identify candlestick chart patterns and create trade ideas based on them.
Candlestick charts help traders analyze market structure and determine whether we’re in a bullish or bearish market environment. They may also be used to identify areas of interest on a chart, like support or resistance levels or potential points of reversal. These are the places on the chart that usually have increased trading activity.
Candlestick patterns are also a great way to manage risk, as they can present trade setups that are defined and exact. How so? Well, candlestick patterns can define clear price targets and invalidation points. This allows traders to come up with very precise and controlled trade setups. As such, candlestick patterns are widely used by Forex and cryptocurrency traders alike.
What is a trend line?
Trend lines are a widely used tool by both traders and technical analysts. They are lines that connect certain data points on a chart. Typically, this data is the price, but not in all cases. Some traders may also draw trend lines on technical indicators and oscillators.
The main idea behind drawing trend lines is to visualize certain aspects of the price action. This way, traders can identify the overall trend and market structure.
The price of Bitcoin touching a trend line multiple times, indicating an uptrend.
Some traders may only use trend lines to get a better understanding of the market structure. Others may use them to create actionable trade ideas based on how the trend lines interact with the price.
Trend lines can be applied to a chart showing virtually any time frame. However, as with any other market analysis tool, trend lines on higher time frames tend to be more reliable than trend lines on lower time frames.
Another aspect to consider here is the strength of a trend line. The conventional definition of a trend line defines that it has to touch the price at least two or three times to become valid. Typically, the more times the price has touched (tested) a trend line, the more reliable it may be considered.
What are support and resistance?
Support and resistance are some of the most basic concepts related to trading and technical analysis.
Support means a level where the price finds a “floor.” In other words, a support level is an area of significant demand, where buyers step in and push the price up.
Resistance means a level where the price finds a “ceiling.” A resistance level is an area of significant supply, where sellers step in and push the price down.
Support level (red) is tested and broken, turning into resistance.
Now you know that support and resistance are levels of increased demand and supply, respectively. However, many other factors can be at play when thinking about support and resistance.
Technical indicators, such as trend lines, moving averages, Bollinger Bands, Ichimoku Clouds, and Fibonacci Retracement can also suggest potential support and resistance levels. In fact, even aspects of human psychology are used. This is why traders and investors may incorporate support and resistance very differently in their individual trading strategy.
Common mistakes when trading with technical analysis
1. Not cutting your losses
Let’s start with a quote from commodities trader Ed Seykota:
“The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.”
This seems like a simple step, but it’s always good to emphasize its importance. When it comes to trading and investing, protecting your capital should always be your number one priority.
When you’re an active trader, it’s a common mistake to think you always need to be in a trade. Trading involves a lot of analysis and a lot of, well, sitting around, patiently waiting! With some trading strategies, you may need to wait a long time to get a reliable signal to enter a trade. Some traders may enter less than three trades per year and still produce outstanding returns.
Check out this quote from trader Jesse Livermore, one of the pioneers of day trading:
“Money is made by sitting, not trading.”
A similar trading mistake is an overemphasis on lower time frames. Analysis done on higher time frames will generally be more reliable than analysis done on lower time frames. As such, low time frames will produce a lot of market noise and may tempt you to enter trades more often. While there are many successful scalpers and short-term profitable traders, trading on lower time frames usually brings a bad risk/reward ratio. As a risky trading strategy, it’s certainly not recommended for beginners.
3. Revenge trading
It’s easy to stay calm when things are going well, or even when you make small mistakes. But can you stay calm when things go completely wrong? Can you stick to your trading plan, even when everyone else is panicking?
Notice the word “analysis” in technical analysis. Naturally, this implies an analytical approach to the markets, right? So, why would you want to make hasty, emotional decisions in such a framework? If you want to be among the best traders, you should be able to stay calm even after the biggest mistakes. Avoid emotional decisions, and focus on keeping a logical, analytical mindset.
Trading immediately after suffering a big loss tends to lead to even more losses. As such, some traders may not even trade at all for a period of time following a big loss. This way, they can get a fresh start and get back to trading with a clear mind.
4. Being too stubborn to change your mind
Let’s read what legendary trader Paul Tudor Jones had to say about his positions:
“Every day I assume every position I have is wrong.”
It’s good practice to try to take the other side of your arguments to see their potential weaknesses. This way, your investment theses (and decisions) can become more comprehensive.
This also brings up another point: cognitive biases. Biases can heavily affect your decision-making, cloud your judgment, and limit the range of possibilities you’re able to consider. Make sure to at least understand the cognitive biases that may affect your trading plans, so you can mitigate their consequences more effectively.
5. Ignoring extreme market conditions
The RSI can reach extreme levels during extraordinary market conditions. It might even drop to single digits – close to the lowest possible reading (zero). Even such an extreme oversold reading may not necessarily mean that a reversal is imminent.
6. Forgetting that TA is a game of probabilities
Technical analysis doesn’t deal with absolutes. It deals with probabilities. This means that whatever technical approach you’re basing your strategies on, there’s never a guarantee that the market will behave as you expect. Maybe your analysis suggests that there’s a very high probability of the market moving up or down, but that’s still not a certainty.
You need to take this into account when you’re setting up your trading strategies. No matter how experienced you are, it’s never a great idea to think the market will follow your analysis. If you do that, you’re prone to oversizing and betting too big on one outcome, risking a big financial loss.
7. Blindly following other traders
Constantly improving your craft is essential if you want to master any skill. This is especially true when it comes to trading the financial markets. In fact, changing market conditions make it a necessity. One of the best ways to learn is to follow experienced technical analysts and traders.
However, if you’d like to become consistently good, you also need to find your own strengths and build on them. We can call this your edge, the thing that makes you different from others as a trader.
Entering a trade based on someone else’s analysis might work out a few times. However, if you just blindly follow other traders without understanding the underlying context, it most definitely won’t work over the long-term. This, of course, doesn’t mean that you shouldn’t follow and learn from others. The important thing is whether you agree with the trade idea and whether it fits into your trading system. You should not be blindly following other traders, even if they are experienced and reputable.