While bitcoin traders have many tools they can use to evaluate the cryptocurrency market, one of the most tried-and-true methodologies is what's called technical analysis. Using this approach, traders can get a better sense of market sentiment and identify key trends, and, with this information, make better-informed predictions.

Technicians (sometimes called 'chartists') take a practical approach, looking at a security’s history (using price charts) and applying various analytical tools to get a better sense of how the market feels about that particular security.

While 'fundamental analysis' – the counterpart to technical analysis – is more interested in determining what a security 'should' be worth, technicians are only concerned with a security’s actual price movements. By looking at bitcoin’s price history, technicians attempt to identify well-known patterns such as 'support' and 'resistance'.

To get a better understanding of technical analysis, it is important to grasp the basic concepts of Dow theory, which has provided the foundation for this practical method for evaluating securities.

Dow Theory provides a few basic assumptions:

1. The market discounts everything. All past, current and even future information is already factored into existing asset prices. In the case of bitcoin, this would include variables such as past, current and future demand, as well as any regulations affecting the digital currency.

The current price reflects all existing information, including the knowledge and expectations of all market participants. As a result, technicians seek to interpret what the price is saying about market sentiment to make educated predictions about what prices will do going forward.

2. Prices movements are not completely random. Instead, they frequently follow trends, which can be either short-term or long-term. Once a security forms a trend, it is more likely to follow that trend than go against it. Through technical analysis, technicians seek to identify trends and profit from them.

3. 'What' matters more than 'why'. Technicians focus more on a security's price history than the specific variables that have created this price movement. While any number of factors could have caused a security's price to move in a certain way, technicians take a more direct approach by looking at supply and demand.

4. History has a tendency to repeat itself. Market psychology is predictable, and traders often respond the same way when provided with similar stimuli. Digital currency markets, for example, have frequently provided bullish responses to key events such as news evidencing rising adoption or greater visibility.

Identifying trends, or the general direction in which a security is moving, can be very helpful for bitcoin traders. However, singling these trends out can be a challenge. Digital currencies can be highly volatile, and looking at a chart of bitcoin's price movements will likely show a series of highs and lows.

However, technicians know that they can look past the volatility and identify an uptrend when they see a sequence of higher highs and higher lows. In contrast, they can single out a downtrend when they identify a string of lower lows and lower highs.

There are also sideways trends, in which a security experiences little in the way of upward or downward movement.

Traders should know that trends come in many lengths, including short-term, intermediate, and long-term.

One technique bitcoin traders can use to more easily identify trends is to use 'moving averages', which help smooth out a digital currency's price fluctuations so market participants can get a better sense of where the price has been going.

The most basic kind of moving average is the 'simple moving average', which is determined by calculating a security’s average price over a specific time period. Traders might look at what bitcoin has done over a five-day or 20-day period, for example.

A similar tool that bitcoin traders can use is the 'exponential moving average', which gives greater emphasis to more recent price values when calculating an average.

By analyzing moving averages, traders can get a better sense of when momentum shifts. For example, if a five-day moving average falls below a 20-day moving average, this development could point to a bull market turning bearish. Should the opposite take place, with the shorter average rising above the longer average, the converse is true.

Chart 1: A five-day moving average (SMA 5) repeatedly surpassing a 20-day moving average (SMA 20):

Another crucial tool is the analysis of support and resistance levels. By identifying these levels, bitcoin traders can help get a better sense of the supply and demand surrounding the digital currency.

The support level is effectively the price at which a large number of traders are willing to buy a security, since they believe it is 'oversold' (ie sold at a price below its perceived true value). As the security approaches this price, market participants step in and purchase it, creating a 'floor'.

For example, if bitcoin prices trade above $1,000 for several days, any retreat to this price level might prompt market participants to believe the currency is oversold and therefore start buying.

Chart 2: Support level (in green):

The counterpart to support is resistance, which is a price level where a large number of traders are motivated to sell a security because they think it is 'overbought' (ie overvalued due to many traders buying at excessively high prices).

For example, if bitcoin prices trade below $1,000 for several sessions, moving toward $1,000 might prompt a significant number of traders to enter sell orders for the security, thereby creating resistance.

Chart 3: Resistance (in green):

Bitcoin sometimes fluctuates between levels of support and resistance, which work together to create a range. This is called 'rangebound trading', and creates opportunities for traders to buy bitcoin when it is near the bottom of the range and sell when it is close to the top.

Chart 4: Ranges of support and resistance:

However, should bitcoin prices exit a trading range, this can result in robust trading activity, significant volatility and a new trend.

For example, if bitcoin prices break through a price level that previously served as resistance, this price frequently ends up serving as a support level. Alternatively, the opposite could happen, with the digital currency’s price falling below support, resulting in this level becoming a new resistance level.

Bitcoin traders should keep in mind that volume plays an important role in evaluating price trends. High volume points to strong price trends, while low volume indicates weaker trends. If bitcoin prices experience a large gain or loss, traders should be sure to examine volume.

For example, if bitcoin enjoys a long uptrend and then declines sharply one day, it is worth checking out volume to get a better sense of whether this downward movement represents a new trend or simply a temporary pullback.

Generally, rising prices coincide with increasing volume. If bitcoin prices enjoy an uptrend, but the currency’s upward movements take place amid weak volume, this could mean that the trend is running out of gas and could soon be over.

Chart 5: Volume rising as the price climbs:

While technical analysis can be a valuable tool in a bitcoin trader's arsenal, those considering using it can benefit from being aware of the criticism brought against this particular approach. Much of this criticism comes from the 'efficient market' hypothesis, which is the idea that market prices reflect all available information.

If this assertion is valid, then there is no value to be had from conducting analysis in an effort to determine when securities are undervalued or overvalued. Efficient market hypothesis has both its critics and advocates, and arguments can be made either for or against the idea.

At the end of the day, it is up to each individual bitcoin trader to consider both sides and determine what they believe.

By leveraging technical analysis, bitcoin traders can gauge market sentiment, identify trends and potentially make better-informed investment decisions. However, there are a few key variables they should keep in mind.

For starters, technical analysis is a very practical approach, looking only at a security’s price and volume.

As a result, relying on technical analysis could potentially cause a trader to either miss out on opportunities to buy bitcoin when it is undervalued or, alternatively, purchase the digital currency when the price may be inflated, at least according to the fundamentals.

To manage this risk, bitcoin traders can potentially combine fundamental analysis with technical analysis. For example, if a bitcoin trader concludes that technical indicators and patterns are telling him to buy, he can help affirm this by evaluating some fundamental data, such as the approaching SEC ruling on the Winklevoss ETF.

Alternatively, a bitcoin trader could leverage fundamental analysis to determine whether bitcoin is undervalued or overvalued and then harness technical analysis to calculate the best point to either buy or sell the digital currency.

Trading chart image via Shutterstock