You might have heard that the cryptocurrency markets are the perfect environment for short-term traders. The incredible volatility of the markets can be exploited to make outsized profits. In this article, I want to talk about the basics of trading indicators.
But first, what are trading indicators? Trading indicators are tools available to analyst and traders for identifying opportunities in the markets. These tools allow us, traders, to understand the markets to a certain degree and use the understanding to position ourselves for future price action.
Before we go any further, I want to emphasize that I will stick to the complete basics in this article.
Oh, and before I forget, I’ve written another article, a guide for trading cryptocurrencies in 2018. The article is an overview of how to approach the markets if you’re interested in trading cryptocurrencies. You should definitely check the article out if you’re a beginner and new to the world of trading.
The Foundation of Market Analysis
In my experience, I’ve learned that the most important thing you, as a trader, need to learn is market structure and how price behaves. This, is in my opinion, is the foundation of chart analysis on which the rest of your knowledge will accumulate and build.
My Early Experience
Allow me to elaborate this point with a personal anecdotal analogy. When I became interested in the markets, I naturally gravitated towards trading. After taking a few random trades, it became clear that I knew absolutely nothing about forecasting, trading or market analysis.
So I went about getting my hands on a few books on technical analysis. Among the first two books I read were Technical Analysis of the Financial Markets by John J. Murphy and Technical Analysis: The Complete Resource for Financial Market Technician.
I learned all of the commonly used tools available to a technical analyst through these books. Armed with my newfound knowledge, I was ready to master the markets and become a millionaire. But as you might guess, it turned out that the ability to use these trading indicators without any context meant absolutely nothing.
I felt even more confused. Here I thought I knew how to read and understand the markets, but I was just as clueless. I could use the tools to make some conclusions, but it did nothing to provide me with the context I needed to understand the markets. And since I didn’t really understand the markets, I couldn’t really trade, at least not profitably.
Little did I know, these tools in isolation meant absolutely nothing. You can learn to use a hammer, but chances are you won’t be able to build a shed just because you figured out how a hammer works.
A Holistic Understanding of the Markets
You might have heard of the Fibonacci retracement tool. It’s a measurement tool used by chart analysts. It is a very important tool, but you can’t just use it to trade. You can use it to measure certain aspects of price action, but unless you understand the context of what you’re measuring and what it means for your trading strategy, it will prove to be useless as far as trading is concerned.
Don’t worry we will talk about trading indicators including Fibonacci retracement and extensions but first let’s look at market structure.
What is market structure? When chartists and traders refer to market structure, they are usually talking about the current market condition in terms of previous price action. Basically, how a market has been behaving.
The ability to understand market structure means that you can infer the state of the market just be looking at previous price action. After you have some context regarding where the market has been, you can whip out your trading indicators to build on that macro view. You can make precise measurements to further corroborate a view.
On a micro level, it is your ability to look at a chart and in an instant and figure out all of the zones of support and resistance. It’s the ability to tell where all of the major confluence zones lie. Most importantly, it’s that ability to know when to risk your capital when to stay flat.
I doubt there is a book for learning about market structure. It is not a set of rules you learn but rather the understanding you develop through conditioning. You study the markets regularly and after a period of time, the charts just make sense. It’s like reading. You don’t consciously read, do you? If you glance over some text, your mind automatically reads it.
Trading Indicators – Trend and Range Analysis
Now let’s go over some of the most commonly used trading indicators. The indicators we will discuss, I believe, every budding trading should be aware of and know how to use. Furthermore, I also want to discuss the best combination of indicators for day trading.
Trends and Trend Lines
Market trends are an extremely simple concept to understand, but in practice, it can be quite difficult, especially when money is on the line. Trading with the trend is the simplest way to make money. It allows you to miss-time the market and still make money. For example, if you bought ether anytime throughout 2017, chances are you would have made money.
We use trend lines to isolate trends but they only become obvious in hindsight. Why would anyone have trouble figuring out if a market reversal had occurred? The simplest way to determine a trend is by looking at the peaks and troughs.
If the market continues to make higher highs and higher lows, you can use the lower lows to draw a trend line. But remember that these lines serve as nothing more than visual aides and have no real bearing on the market. You might have to redraw the lines without any change in the trend.
Trading Ranges – Support and Resistance
When markets are not trending, they are usually trading in a sideways range. These periods could be sideways movements, meaning, there won’t be any new highs or lows. They appear between trends and it is important to understand them if you want to be a trend trader.
So what are support and resistance zones? A market high is usually referred to as a resistance and a market low is referred to as a support. When the price gets high enough, it attracts sellers into the market. Chartists refer to such price levels as resistance. Similarly, when the price falls beyond a point, buyers enter the market forcing the price to rise, this is called support.
You will find support and resistance zones whether in a trending or a ranging market. Your ability to identify and expect support and resistance levels is important for developing a viable trading strategy.
Moving Averages (MA)
Moving average is another extremely popular indicator. It is one of those indicators that almost every trader uses. MAs are used to smoothen price data, essentially, it creates a smooth single line, which represents the average price.
There are several ways traders use moving averages in their trading strategies. Its most basic use is to determine if a market is trending or ranging. If the moving average is moving mostly horizontally, then the price is most likely ranging.
Another way to use MAs is through crossovers, which is used to determine buy or sell entries. You start by plotting two MAs on your chart. There are a number of combinations you can opt for but the most widely used are 200-day and 50-day moving averages.
A buy signal occurs when the fast moving average, the 50-day MA crosses above the 200-day MA. A sell signal occurs when the 50-day MA drops below the 200-day moving average. You can also incorporate other metrics such as the price should also cross beyond the MAs and then pulls back to retests the MA, where the MA acts as a support or resistance.
Trading Indicators – Volume Analysis
Basic Price and Volume Analysis
Volume can help us gauge the strength and viability of a breakout or an existing trend. When prices are rising, you should also see an increase in volume accompanying the rising prices. If the price is rising but the total volume is decreasing, you could expect the trend to be losing momentum, as there are fewer buyers beyond the rally.
If price breaks out of a trading range, you should look for a corresponding increase in trading volume. Generally speaking, breakouts on weak volume tend to reverse and head back into the trading range.
Another important thing you about volume analysis is how volume increases at major turning points. The markets almost always experiences huge spikes in volumes during price extremes, meaning at a high or a low before a price reversal. Look at the chart above for an illustration of spikes in volume at key turning points.
On Balance Volume (OBV)
On Balance Volume or OBV is by far the most popular volume-based trading indicator. The indicator increases or moves up when prices rise and decrease in value or moves down when prices decline.
OBV is most useful when a market is in a consolidation pattern or trading within a trading range. It can help us identify the direction of a potential price breakout. If OBV breaks its own support or resistance, the direction of the break signifies the direction of the subsequent price move.
Moreover, OBV can also be used as a confirmation of future price action. If a break out occurs, you want to see a corresponding change in OBV that justifies the move. For example, if prices are increasing, you want OBV to be increasing and making new highs as well.
Most traders are used to analyzing volume as a histogram plotted underneath the price chart. Volume profile is a bit of a different approach to volume analysis. Instead of viewing volume in terms of time, it allows us to view volume in terms of price. So instead of seeing how many bitcoins were traded in an hour, you get to see how many bitcoins were traded in a price range.
Volume profile analysis adds another dimension to our analysis and can help us get that edge we need to make money in the markets. Volume profile allows us to isolate price ranges that might be of interest to us. For example, at what price did most of the volume of transactions took place?
Such information can help us identify support and resistance based on at what price levels would buyers or sellers would enter the market. A key point to remember when using volume profile is that high volume is associated with trading ranges and low volumes represent trends.
Trading Indicators – Momentum and Trend Analysis
Relative Strength Index (RSI)
RSI is an oscillator-based indicator, meaning, it oscillates between a range of zero and hundred. RSI is an extremely popular indicator and can be used in a number of ways. First off, it is used as a means of determining if a market is overbought or oversold.
According to the RSI, a market is overbought if the indicator is above 70 or 80 depending on parameters of the indicator. An overbought market is one that is due for a correction if not a reversal. If the indicator is below 30 or 20, the market can be viewed as oversold and due for an upwards correction.
A very important thing to remember when using RSI is the market condition. When the market is in a strong trend, it is not unusual for the RSI to reach 70 or 30 and stay there for extended periods of time. For example, during bitcoin’s bull market throughout 2017, the market was overbought but continued higher anyway.
Another popular way to use RSI and probably more effective is to measure the momentum of the market. If the price makes a new high, you want the RSI to make a new high as well. Failure to do so represents divergence between the price and the RSI, which means a weakening of market momentum.
Moving Average Convergence Divergence (MACD)
The MACD is another extremely popular oscillator-based indicator. It is used both, as a momentum and trend following indicator. The most basic MACD strategy is to look where the lines on the indicator are. If the lines are above zero for a sustained period of time, the trend is likely towards the upside. If the lines are below zero, chances are the trend is towards the downside.
Aside from identifying the trend, the indicator can also help determine entry signals. There are two lines on the indicator, a fast MA, and a slow MA. A buy signal is triggered when the fast line crosses above the slow line. A sell signal is triggered when the fast line crosses below the slow line. After the crossover, if the lines cross the zero mark, it can be taken as a confirmation signal.
Lastly, MACD, just like RSI, can also be used to determine the momentum of a trend. In order to gauge if the momentum is increasing or decreasing, you go look for divergence between the price and the MACD. If used along with RSI, it can be an extremely powerful tool in helping you determine market momentum with fewer false signals.
Trading Indicators – Misc
Unlike most of the indicators we’ve covered so far, Bollinger Bands are different. They are volatility bands that help us determine various standard deviations of price action. The indicator offers an excellent way to gauge when volatility is increasing or decreasing.
When volatility increases in the market, bands around the price expand and when volatility decreases, the band contract. There is no one correct way to use this indicator. Instead, it works best if you combine it with another technique to form a trading system.
Let me give you an example of how you can use the Bollinger bands. Assuming there is a downtrend in the market. You can use the bands to buy sharp dips for quick short-term profits as the price reverts to the mean. Look at the chart for an illustration of the example.
Fibonacci Retracements and Extensions
Unlike many of the indicators we’ve looked at so far, Fibonacci is not really an indicator by itself. It is more of a measurement tool based on ratios found in the Fibonacci sequence. It is used mostly to determine the extent of a correction in a trend.
You can’t really use a Fibonacci tool by itself. This is because it is just a measuring tool. But there are a number of trading systems and strategies that utilize Fibonacci ratios, which makes it extremely useful. For example, Scott Carney’s Harmonic Patterns are all based on a combination of Fibonacci ratios.
The Fibonacci tool is also used to determine the extent of a move. For example, if I want to scale out of a position, I could take partial profits out of a position when the price reaches the 1.27 fibonacci level of the previous move, meaning, 127% of the previous move. This is a bit advanced and am I sure we will get into more detail in future articles, but for now, you can look at the chart for an example.
We’ve talked about a number of trading indicators but I can’t end the article without touching the subject of day trading. I know a lot of people want to get into day trading and would like to know about the best combination of indicators for day trading.
What I want you to understand is that nothing fundamentally changes when you day trade as opposed to taking trades that might last a week or a few days. The only thing that changes is the timeframe.
If you are day trading, you are operating in the shortest possible time frame. Instead of looking at the daily, 4-hourly or hourly charts. You will be using 15-minute charts as your analysis time frame and 5 and 1-minute charts as your trading or entry time frame.
So basically, you have to make snap decisions. The indicators will adjust according to your time frame but the thing is, conditions change rapidly. You could have a buy setup that might not be there after a minute or even seconds.
A Day Trading Strategy
An overbought market according to the RSI could be oversold just a few minutes later if volatility is high enough. You need to understand this bit. Things happen really quickly in the shorter time frames. I am not trying to discourage you. I just want you to be prepared so there aren’t any surprises.
Anyway, the best combination of indicators for day trading, in my opinion, would be the RSI used in conjunction with Bollinger Bands. You can look for overbought or oversold conditions and enter when the price extends beyond the Bollinger Bands. Obviously, you would have to take really quick profits as your trades wouldn’t last very long.
You obviously won’t use Fibonacci retracements. Or need sensitive indicators that respond quickly to fast moving market conditions. You could also opt for other complete systems such as the DMI, parabolic SAR or Ichimoku Cloud.
Trading Indicator Software
Of course, you would need a decent platform in order to be able to use all of these indicators and tools and analyze the markets. Here are a few recommendations. You can check them out and see which trading indicator software you like best.
TradingView is an excellent web-based charting software. It has its own social tools and a vibrant community of traders and analysts. Not only can you learn from its social tools, but even check how some of the traders on the platform have fared over the years. You can publish your ideas on the markets and get feedback from other traders.
Coinigy is a charting platform that was created specifically for digital currencies. You can access price data from almost all of the popular cryptocurrency exchanges. You can even trade directly off the charts, which is an important feature for day traders, where speed is an important factor. All-in-all, Coinigy is an excellent charting software and you should definitely check it out.
In the end, it is important to remember that all of these indicators are just tools. How you use these tools is far more important than the tools themselves. The last thing I would like to say is that, don’t just learn how to use these tools. Understand the meaning of the information you get from using these tools.
For example, you understand what overbought and oversold is in the context of RSI. But what happens in the market after the indicator tells you it is overbought? Does the market completely reverse? Or is there just a pullback? How long can a trend continue while in a state of being overbought?
Your ability to answer these questions is far more important than your ability to simply use these tools. Hopefully, I will do another article on how to get answers to these questions. So until then, keep an eye out for more articles.