Several Misunderstandings About Technical Analysis

Newcomers to crypto trading may struggle to make a profit until they know how to read trend lines, chart patterns, and candlestick patterns. Most amateur traders will be punished mercilessly by the market, ending up losing every penny in their pocket. This is because wrong concepts can lead one to neglect the following three pillars of crypto trading:

1: Ignoring the essence of the market and transactions.

Understanding the market is the basis for investors to gain a foothold in the market and make profits. It is also the cornerstone, around which traders should construct their system of trading concepts and trading strategies.

The market is a place for the redistribution of wealth, and it is human emotions that control the ups and downs of prices. Essentially, the formation of price is a consequence of competition between long and short orders.

Subject to changes in human emotions, the market movement shows great unpredictability, instability, and volatility. Driven by a game of various market forces, and affected by policies, news, funds, and emotions, the price change follows different moving trajectories based on the length of the observed period. Although the market moves in a disorderly and random manner in the short term, a longer term take always shows the general trend.

2.Neglecting timeframe influence when using technical patterns to detect trading signals.

The technical patterns can be divided into different time periods, such as 5 minutes, 15 minutes, an hour, a day, a week, etc. Generally speaking, the long-term trend dominates the tendency formed during a short period of time. That means if the long-term trend persists, the short-term tendency will not end either. Therefore, the strategy of selling and buying assets by following the peak and bottom signals given by short-term patterns will not be successful in the market. It’s unwise to discuss trends without mentioning the timeframe. Only by observing the price’s moving trajectory during different trading cycles can one get more accurate trading signals. We have every reason to believe that the current trend will continue as long as the long-term tendency remains stable.

Big data also proves that those who trade by following the trend can get more returns than those who try to profit from short-term price fluctuations. This is how technical analysis plays its role: it helps traders discover trends and follow them.

3.Third: Relying too heavily on a single trading signal and applying it to all trading scenarios.

It’s important to understand that the marketplace is not a place where one trick works everywhere. In other words, there is no technical indicator that can be universally applied to all trading scenarios. There are two types of trading signals: trending indicators and oscillating indicators. Trending indicators include Bollinger Bands, ADX, moving average, etc., while oscillating indicators mainly include RSI, KDJ, ROC, and CCI. One common mistake made by novice technical analysts is using an indicator without paying attention to its specific scenarios, which can generate false signals and lead to significant losses.

Experienced traders will combine different technical indicators to form their unique analysis system based on years of practical trading experience, enabling them to handle various market situations effectively.

In short, technical market analysis is subjective, and the effectiveness of a tool depends on the person using it. It’s important to remember that the capital market involves both risks and returns. Sometimes, if you experience a loss, it’s not the tool’s fault but your approach to managing the risk.

The theoretical basis for the right use of technical analysis

Technical analysis is based upon the following three assumptions or prerequisites:

1. Market behaviors are inclusive of and digest everything;

2. Prices evolve by following a certain trend;

3. History repeats itself.

Technical analysis is a method used to analyze and evaluate market trends through price lines and charts. In other words, the reason why technical analysis is effective is that prices follow a certain law of evolution. This reflects the third assumption listed above: history repeats itself, which is also the most crucial among the three assumptions.

Why does history repeat itself?

To find the answer to this question, we must understand the relationship between three factors that influence the market: price, behavior, and psychology. The “price” is the representation of market behaviors. It is the result of the game between the long and short sides. The trading behavior is influenced by the trading psychology of the selling and buying forces. Trading psychology mainly includes two types of emotions: fear and greed. Because there is inertia of how humans behave or react emotionally in a certain situation, the price trend moves along an established path at the critical moment of a trading cycle.

By revealing such price inertia, technical analysis can help us gain a good understanding of market conditions, and can reflect price trends during a certain timeframe. Traders can analyze the optimal price for buying or selling assets from the support and resistance levels in the market. Each investor can develop an analytical system that fits their investment habits and needs by integrating the use of patterns that cover different time periods, providing a prediction of the market from multiple angles. By doing so, all investors, whether they are short, medium, or long-term investors, can take action at the right moment to maximize their returns in trading.

When Charles H. Dow invented the stock market average price index on July 3, 1884, the index initially included only eleven stocks, nine of which were from railway companies. The index then evolved into two indices in 1897: the industrial stock price index, which was composed of 12 stocks, and the railway stock price index, which contained 20 components. By 1928, the industrial stock index had expanded its coverage to 30 stocks, and in 1929, it was further extended to include the utility stock price index. Despite the appearance of these new indices one after another, they all originated from Dow’s 1884 price index.

In the stock market, the history of market technical analysis can be traced back to a century ago, and after one hundred years of constant evolution, a mature analytical system has been established. The analysis methods used in the crypto market share the same theoretical basis as stock analysis rules, and are developed based on the mature stock analysis system and their use cases, but with proper adjustments to certain details to become more adaptive to conditions of the crypto asset market.

Why do we bother introducing this background? Why is Dow’s Theory so important? The answer is readily available. It is because Dow Theory is the source of almost all widely used technical analysis theories, or we can say that those theories are, in essence, the representation of Dow Theory in various forms. Dow is the founder of the technical analysis system.

Mainstream technical analysis schools

Technical analysis users can be divided into five mainstream schools: Indicatorist; Graphist; Patternist; Candlestickist; Wavist.

1、 Indicatorist

Indicatorist considers all aspects of market behavior by establishing a mathematical model to calculate the required indicators, which they believe can reflect a specific aspect of the market condition. The value is called an index, which, together with relations between different indices, can directly reflect the state of the market and provide guidance in the decision-making process. What we can read from those indices can hardly be seen in market reports.

Commonly used indicators include VOL, MACD, KDJ, RSI, MA, etc., and they are divided into three groups: trend indicators, oscillator indicators, energy indicators, etc.

2、 Graphist

Graptists draw straight lines on the chart according to certain methods and principles, and then speculate on the price trend of market prices based on positions of straight lines on the chart.

The method of drawing lines is crucial as the accuracy of the analysis can be directly affected by whether those lines are drawn correctly. After long-term practices and research, there are many different line-drawing theories available in the market. The famous ones include trend lines and channel lines. In addition, golden cross lines, Gann lines, and angle lines are also commonly used in trading. One can greatly improve their success rate in the market if they can wisely use those lines.

3、Patternist

Patternists believe that from the shape of the price trajectory, one can infer whether the market is on a bullish or bearish trend, which can provide certain guidance in trading. There are more than a dozen well-known patterns, including M head, W bottom, head-shoulders top-bottom, etc, which are all resultant from pattern observation by generations of traders.

1. Candlestickist

Different K-lines are tools for Candlestickists to speculate on the strength comparison of long and short sides. By comparing the force of these two aides using K-lines of different forms, they figure out the stronger and weaker forces and further determine whether the dominant force will have the absolute competitive edge or the situation can be reversed. The K-line chart, the most important chart for all technical analysis, is described in detail in a dedicated article.

Considering there are even more than a dozen forms of K-lines that can be found in a one-day chart, it will be quite difficult to establish how many K-line combinations we can get from a chart that covers a longer trading cycle. Through years of practice and experience, traders have already found several sets of K-line combinations that prove very effective in helping them judge the market trend. In the future, new methods will continue to be created, to become useful tools for traders.

5.Wavist

The wave theory originated from American Charles J. Collins in 1978 in his monograph entitled “Origin of Wave Theory.” However, the actual inventor and founder of the wave theory is Elliott, who proposed the original idea of wave theory as early as the 1930s.

The wave theory compares upward and downward price changes and the continuous rise and fall in different periods to the movement of waves. The sea waves rise and fall by following the laws of nature, so market prices also rise and fall according to certain rules.

Simply put, a price increase will experience five waves, while it takes only three waves for the market to go down. By counting the number of waves, we can predict when the current trend will take a turn - a bearish trend reverses to bullish, or vice versa.

Unlike other school theories that can only detect a trend after it is formed, the wavists’ method enables traders to predict the peaking and bottoming of prices long before the situation actually arises. However, wave theory is also recognized as the most challenging technical analysis tool to use. In fact, traders may become bewildered by the big waves that cover small waves and countless waves that are intertangled with each other. The use of the wavist theory is a matter of “being wise after the event.” Although one can always get the right “5 and 3” wave counts after a complete market cycle has ended, it is almost impossible to make the right predictions if the trend is still developing.

The above five technical analysis methods provide different perspectives for traders to understand and consider market changes. Despite the fact that some of them have a solid theoretical foundation, while others don’t, one feature that is common to all of them is that they have stood the test of the market and are finally preserved. In other words, they are all the essence of the experience and wisdom of countless traders.

Although these five technical analysis methods analyze prices in different ways, they are not mutually exclusive because they share the same ultimate purpose - to assist traders in understanding the market. Therefore, different tools can be used in combination to obtain a more accurate reading of market trends. For example, indicators may also use some tangent and morphological conclusions and techniques as a supplement in market analysis.

The different nature of these five technical analysis methods determines that they all have their unique focus in application. Some emphasize long-term trends, while others focus on short-term ones; some concentrate on the relative position of prices, while some on absolute positions; some pay attention to time, while others emphasize price. Regardless of how these methods differ in terms of their focus of attention, they all recognize one principle: as long as profit can be made, traders can resort to whatever methods they consider appropriate.

Establish your own analysis framework

1. Build solid theory knowledge
   We recommend that all users carefully read and truly understand Dow Theory. As the theoretical basis and classic reading material of technical analysis, it can help traders avoid many detours in market analysis. Trading experience determines the lower limit of profit that one can make, while the upper limit of revenue is subject to the depth of one’s theoretical foundations.

2. Understand the foundations of trading and see through the weakness of human nature
   The essence of trading has already been discussed earlier, so it will not be repeated here. However, another factor that can affect your investment income and determine whether you can survive and profit or are eliminated midway is the emotions and psychology you have during the trading process. All experienced traders understand the importance of maintaining a healthy psychology when facing market volatility and fluctuations. They also recognize the limitations of human nature and respect the market. By acknowledging these limitations and taking calculated risks, they can achieve greater success in the trading market.

3. Experience is the best teacher and reflection matters
   In addition to theoretical study, the best way to improve trading skills is to participate in actual contract trading and summarise experiences gained from each trading case. Only in this way can one understand the limit of technical analysis in predicting the market, and know where the limit of their abilities lie, so they can constantly adjust their analytical system to improve its accuracy.

4. Build and improve the trading system
   One should conduct scientific position management, and exercise effective risk management in trading. After an initiative trading system is built, you should put the system to the test in practice, continue to improve it, and finally build a complete framework that best suits your own trading habits.

Summary

The course “Technical analysis: a useful tool to understand trends in contract trading “contains an introduction to the basis of K-line, trend, and technical patterns, which actually is a summarization of the essence of classic technical analysis methodology, while eliminating the outdated part of those theories. We hope the articles can help you understand more about these critical trading tools and popularize their use in trading.

course “Technical analysis: a useful tool to understand trends in contract trading “

Disclaimer

Please note that this article is for informational purposes only and does not offer investment advice. Gate.io cannot be held responsible for any investment decisions made. The information related to technical analysis, market judgment, trading skills, and traders’ sharing should not be relied upon for investment purposes. Investing carries potential risks and uncertainties, and this article does not guarantee returns on any investment.