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On Bitcoin and Technical Analysis

In response to my last post, in which I pointed out the “cup-and-handle formation” that had completed prior to bitcoin’s latest parabolic price move, a reader commented with an often repeated opinion. He said, “Chart analysis is the modern equivalent of reading tea leaves.” Perhaps he is right. After all, there is never any shortage of traders misreading markets and mistiming entries.

However, patterns and fractals continue to emerge time and time again. At the very least, I have always thought that technical analysis is somewhat of a self-fulfilling prophecy, in that when enough people believe a pattern to be forming, they buy or sell accordingly, and the pattern tends to come to fruition. The first cup-and-handle, which began in late April and completed in late September / early October, was speculated about at length when the rally began following the Silk Road crash. This formation came to fruition.

The “cup-and-handle” formation

The reader remarked that technical analysis is not scientific, and that it is not predictive—otherwise “there'd be a bunch of expert chart analyzers who were filthy rich. But instead they make their money selling their snakeoil to other people.”

To this I had to say—no one said it was scientific. Technical analysis is not scientific; it is not exact. That does not mean it is logical to conclude that it has no relevance or predictive power. There are many technical analysts who became very rich—many have had technical indicators named for them because of their high rate of accuracy. In this day, technical indicators may be used to sell a book here or there, but you can't really argue that indicators used by countless day traders and mid-term traders are “snake oil.”

I tend to follow several analysts who consistently make correct picks based on technical indicators. Maybe the profits I have made on their analyses have been based purely in luck—and their profits as well. Who can be sure? It is remarked that since many traders lose (presumably based on trading technical indicators), that such indicators are not predictive. This, of course, fails basic logical tests—it says nothing of the accuracy of said traders’ analyses. Indeed, most traders are losing traders. However, this says absolutely nothing about the validity of technical analysis.

Technical analysis is not as simple as seeing one pattern or indicator and trading based on it. One must look at several indicators for confirmation, and even then, it is only probabilistic—there is never any such thing as certainty in markets. But probability is the name of the game in trading. A pattern forming that repeatedly occurs in markets is simply a probabilistic feature from which to interpret, in addition to many other indicators.

As technical analysis is not scientific, it can't be proven. Nonetheless, there have been many indicators that have been noted for high rates of accuracy. A brief look into some technical indicators and those who formulated them will often reveal discussion about their accuracy and persistent use by professional traders.

To someone who takes the position that technical analysis is “reading tea leaves,” I would be curious to know a few things:

If one looks at a Moving Average Convergence-Divergence (MACD) indicator, which is an oscillator based on moving averages, and sees a “bullish divergence” where the shorter-term EMA diverges further above the longer-term EMA, are we not seeing positive upside momentum? And further, is positive upside momentum not something that should be observed and analyzed?

If one looks at the Relative Strength Index (RSI), he is observing the speed and change of price movements. If there is a noticeable momentum reversal on RSI that diverges from price movement, is that meaningless? Or could it indicate that the momentum of the market is changing, in spite of a continuation in price movement?

I have to think that someone who discounts technical analysis on the basis of a lack of scientific rigor also discounts the validity of economics—which is inherently absent the conditions necessary for empiricism—and psychology, which is predominantly anecdotal. That’s all well and good. I also take anything that lacks scientific rigor with a large grain of salt.

However, in analyzing markets, these are our limits. Market psychology is an inherently unscientific matter. Charting techniques are simply attempted visualizations of market psychology (e.g. a “triple top” as a bearish sign is quite literally the market’s unwillingness to break a particular resistance) that traders attempt to fit in with other indicators of trend and momentum.

The “triple top” formation

I can’t agree with arguments that—for example—measuring the rate at which price movement is changing, or the rate at which volume is increasing/decreasing as price moves, has nothing to do with the notions of buying (or selling) pressure, or momentum. And those things, by definition, are inextricably linked to trend continuations and reversals.

Does technical analysis work? The fact that most traders lose is not evidence that it does not—this would be the case with or without technical analysis. I don’t know the answers, but I’d be lying if I said I thought that the “tried and true” indicators that traders have been using for decades were useless. But as I said, take it with a grain of salt, and take other forms of analysis—of fundamentals, for instance—into consideration. And be careful trading the bitcoin market!


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