Fundamental Analysis
In the traditional investments world, fundamental analysis involves evaluating the financial health and viability of a company using its financial statements in order to figure out itstrue value. This doesn‘t work for cryptocurrencies since there are no financial statements. At its core, it focuses on solving the question of “WHY” the price is moving in the market the way it is and helps us anticipate future prices. In order to do that we look at the basic drivers of any economic situation– supply and demand.
Demand
Several factors affect the demand of a cryptocurrency such as user adoption, trading, and transaction activity levels. User adoption is perhaps the strongest factor in determining a cryptocurrency future. Bitcoin, the original cryptocurrency, is the highest used of all coins. It is becoming more mainstream every day. Other rivals such as Ether from Ethereum also have a strong adoption rate.
Trust is another demand driver. This might be the trust in the coin‘s security, thestrength of its blockchain, ability to hold its value, thecommitment of the development team, etc. If the market feels any of these are threatened in anyway, the value will go down. Government involvement has also gone a long way to increase the trust level of these digital coins. There hasn‘t been as much resistance as speculators original thought there would be, partially since these large institutions see value in blockchain technology.
Speculators make up a strong driving force in determining value on an asset. Since there are always new updates, developments, ICOs and regulation changes, speculation is constantly happening and shifting. This is one reason for the high volatility of the cryptocurrency markets, often soaring one day and swinging down to crash in a few short days.
Supply
Determining demand for a cryptocurrency is complicated by its very nature. However, it‘s that nature that makes the study of supply simpler. A cryptocurrency usually has limits on its total supply and even on the rate of when new coins are released. These limits are built into the code itself and can‘t be changed. The total supply amount can be found through research online easily, as well as information on when supplies will run out. However, there are the cases of ‗dead‘ coins. These are coins that haven‘t moved in a long time for whatever reason perhaps because a wallet was damaged or keys were lost.
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Other Indicators that Determine the Optimal Price of a Coin
The optimal price of a coin is determined by several important factors other than supply and demand such as the blockchain difficulty level, media influence, innovation, etc. Let‘s go into detail on some of these key factors.
Energy Usage
You might be surprised to learn that the required electricity needed plays a large role in mining. This is because the energy required to secure blockchains can be very high. Proof of Work (POW) blockchains which are the most common and also require the most energy. To put this into perspective, the amount of energy required to manage the Bitcoin blockchain is equal to the amount a small country would use in a year. This puts a strain on the resources of miners, an integral part of the cryptocurrency market.
Difficulty Level
Mining difficulty refers to the measure of how difficult it is to find a hash below a given target. Blocks must have a hash below a pre-set target to be considered valid. The perceived value of a cryptocurrency will increase the more secure a blockchain is and the higher the mining difficulty. It also increases the energy usage needed and makes it more difficult to get coins through mining.
Utility
The use of a cryptocurrency also plays a role in its value. If it doesn‘t have a strong use, like acting as a form of currency (Bitcoin) or to execute smart contracts (Ether onEthereum), then there will be lower perceived value.
Public and Media Perception
Cryptocurrency has had its share of both positive and negative public perceptions. The media has played its role in reporting these positive and negative developments which are to be expected. People can react positively to the innovations that come from this new technology. They can react strongly to the often volatile nature of the cryptocurrency market. It also has had some negative associations with illegal activities. There have been hacks to major exchanges that have affected the coins as well. These types of situations can have a huge impact on the price of a coin or the entire market.
Bitcoin’s Health
Bitcoin is the oldest and strongest of all cryptocurrencies. It is perceived to be almost like a ‗reserve currency.’ When the price of Bitcoin fluctuates, it often influences the price of all other currencies.
Investors
Investors have more of an effect on coin prices than you might think. For example, when an investor or small group of investors buy a large percentage of a coin‘s supply, they can spark an upward movement of the coins market price.The ability to affect a coin‘s price this way is especially truewhen investors buy large amounts of smaller, lesser-known cryptocurrencies. It is true; some investors might do this to try then to ‗pump‘ the price and then ‗dump‘ their coins for a greater return – an act that is illegal. However, changes in prices because of their large investment can be accidental as well. When investors, particularlywell- known ones, make a large investment in a small coin, this can provide others with the confidence to also buy. This increases demand and therefore the price of the coin.
Scams
Unfortunately, there have been cases where cryptocurrencies have been developed as a scam. This usually takes the form of heavy marketing efforts promising the next big technology but little development facts to support the claims. In these situations, it is typical that the developers ‗premine‘ the coin supply before being released. They hold a large amount of its supply, and after the coin is valued, they sell their coins. The dump into the market will crash the value for any other investors. These scammers will have a large sum of money for their efforts. As mentioned before, this ‗pump and dump‘ strategy is considered illegal. Sadly, it is difficult to prosecute them as the law has not caught up with cryptocurrency markets fully throughout the world.
Market Dilution
More and more new cryptocurrencies are entering the market at a rapid pace. Many of these are heavily based on the Bitcoin source code, don‘t offer any new innovations or have little to no practical utility. This market dilution makes it increasingly difficult for promising altcoins to compete.
Innovation
Bitcoin gave us blockchains, Ether is used with smart contracts, Peercoin uses a combination of both POS and POW systems. Despite market dilution, coins do come out with new innovations in technology. It doesn‘t guarantee a currency will become strong in the market, but it does affect theprice.
The Law and Government
In some countries, cryptocurrencies are banned while in others they are being integrated into society. For example, in the fall of 2017, both South Korea and China banned ICOs because of investment practice concerns. The laws and tax policies surrounding cryptocurrencies are being formed at a rapid pace in hopes of keeping up with the growing market. However, due to the limited ability to control cryptocurrency by the very nature of its network, law and rules can‘t always be enforced.
Instability
This is a new type of financial market which means that there will be and is instability. The price of a coin can change rapidly, especially when you consider all the factors that have been covered in this section. This does make investing in cryptocurrency riskier. However, volatility is decreasing over time. Always make sure you properly research your options and know your limits before investing.
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Bear & Bull Markets
The term bear and bull markets originally were used in relation to the stock market, but the same principals of these trends can be applied to the cryptocurrency market. An easy way to remember the difference between the two is by the animals they refer to. A bull will move its‘ horns upwards to attack while a bear will swipe down with its‘ paws. If the market shows neither pattern, it is a sideways market, and it is best to delay any transactions until a direction begins to show. However, it can be difficult to predict when trends will shift because both trends are based on the emotions and speculative opinions of traders and experts.
Bear Markets
A bear or bearish market is one that is showing lower highs and lower lows. For example, let‘s say the price of cryptocurrencies fall because of strict regulations from a large government body. The market sees this, their trust begins to waver, and some begin to sell. This continues as the markets dip more and traders anticipate continued losses.
There is a difference between a bear market and just a correction. A correction is often short-lived, lasting fewer than two months. Corrections are a positive situation, allowing investors to buy into the market at a discount price. However, bear markets are the opposite. There can be no guarantee when the losses will stop and where the bottom might end up.
Bull Markets
A bull or bullish market is when the market is showing higher highs and higher lows. Bull markets are created by high optimism, confidence and increased trust that values will hold or increase. A bull market is a good indication of a strong and growing economy. In the case of cryptocurrencies, improvements in technology, increased adoption rates and positive changes in regulations can be triggers.
Technical Analysis
Technical analysis is the study of historical price movement by using charts and graphs. The goal is to be able to identify patterns, and price patterns tend to repeat themselves in the markets. This form of analysis along with fundamental analysis will help you make better predictions and become a stronger trader.
Whenever we are using technical analysis, we are using a variety of charts that measure different aspects of the price movement. We refer to these charts as technical indicators or indicators. There are dozens of indicators that you can use whenever you‘re trading. Each of these indicators will have at least one strategy that you can apply to anticipate the future price action.
To access the indicators, we will need to use a charting systemthat will allow us to look at a variety of indicators and even change some of theparameters of the charts to personalize our analysis to the type of tradesthat we will execute. Some of the popular charting systems areMetaTrader, FreeStockCharts, or NetDania. Each of these platforms has aslightly different layout and offers different features. Most of the websites areeither free or offer a free version that will allow you todecide which one suits you and your trading style. Some examples of technical analysis indicators are RSI, moving averages and, candlesticks. We will be reviewing these and others in this chapter.
Candle Sticks
The most important technical indicator that any new cryptocurrency trader should learn is the Japanese Candlestick chart. It‘s a technical indicator that was developed in Japan by rice traders in the 17th century to monitor the rice trade. Most of the technical indicators that you will learn in the future will fit perfectly on top of the Japanese candlestick chart. In fact, it is highly recommended that you learn 2 to 3 other technical indicators. When combined, you will be able to make wiser trading decisions.
Anatomy of a Candlestick Chart
The chart itself works on an X (horizontal) and Y (vertical) axis. The X-axis shows us the time that has passed up until the present time, and the Y shows us the price of the coin. The candlesticks exist between the two as colored blocks. Depending on the charting system you use, the blocks could be red and green, or other charts use red and blue. Some of the blocks will be long, some will be short, some will have lines coming out of the top and bottom of them and others will have no lines at all. Alone, a candlestick doesn‘t offer much information. The more candlesticks you have, the more you can analyze how the candlesticks interact with each other, and that will allow you to understand better how the price will move in the future.
The body of the candlestick represents a period of time and are colored to show us which direction the price moved. Depending on the time frame that you have set your charting system to, each candlestick could represent a variety of time periods.
The color of the candlestick will let us know whether the price went UP or DOWN during the period. Different charting systems can show different candlestick colors. If it‘s a blue or green candlestick, this means that the price moved up for that period of time. If we have a red candlestick, it‘s just the opposite. It means that the price is moving down for that time period.
The top and bottom of a candlestick have their meanings too. The top of a red candlestick shows us what the price was whenever the candlestick started. The bottom of a red candlestick shows us where the priced stopped. For a blue or green candlestick, it‘s the opposite.
Shadows or wicks of candlesticksare the lines that come out of the top and bottom. They show us the full price movement during the candlestick‘s time period as the price constantly moves in the market. For example, if you see a red candlestick with a line coming out of the top of it, it means that the price moved higher than where that candlestick started during itstime period. If you see a wick coming out of the bottom of the candlestick, it just means that the price went lower than where it closed during that time period. The same holds true for blue and green candles.
Using Candlesticks to Analyze Trends
When looking at a candlestick chart, you are trying to see a pattern where the price is clearly moving in one direction for a period of time. You can spot a trend when a series of candlesticks are traveling in a direction. Therefore analyzing just a handful of candlesticks isn‘t very helpful. Trends can be done in an hour or last months. There are upward trends where buyers are in control of the markets, and the price is moving in a general upwards direction. There are also downward trends where the sellers are in control of the market, and the price is moving in a generaldownward direction.
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Fibonacci Retracements
A Fibonacci retracement is a tool used in technical analysis. This tool refers to areas on charts that show expected areas of support and resistance;when the price of a coin stops going lower that is the support level and when the price stops going higher that is the resistance level.This is useful information because it can identify the best places for price targets, stop losses and other transactions.
Areas of support and resistance are visually represented by horizontal lines at key Fibonacci levels. These levels are created by drawing a trendline between the highest and lowest price of a period. The tool will then divide the vertical distance by key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. These ratios are mathematically significant numbers that occur in nature and often for some reason in financial markets. Historically, after a significant price movement up or down in the market, the new support and resistance levels are often at or near these lines.
These levels don‘t move with the chart as moving averages would. This allows traders to better predict and react to the market when price levels are tested.
These ratio levels show places where it is usually expected that the market will struggle then fall lower or break to a new height.
The most significant Fibonacci retracement level to watch for is the 0.618. This is the inverse of the golden ratio, 1.618 or phi. The 0.618 retracement level tends to be the maximum pullback zone where fear climaxes as the final sellers throw in the towel and bargain hunters rush into the stock to resume the uptrend. On downtrends, the 0.618 price level should be where the final buyers are exhausted as sellers take the opportunity to unload their positions and short-sellers jump off the fence to push down the price and resume the downtrend.
Fibonacci retracement levels can be used as triggers for buy order or drawbacks in an uptrend. In a down trending market, you can use these levels to short sell. As mentioned before, use more than 2 to 3 indicators to strengthen your predictions. For example, a 200-day moving average that overlaps with a retracement level would indicate an even stronger support or resistance point. Tip: Always look at the 0.618/61.85 level as it is the most important one. This is where the market tends to bounce back out of fear.
MACD Indicators
MACD stands for ‘moving average convergence divergence.’ It shows the shows the relationship between two moving averages of prices. While the name may sound complicated, it is simple to use. MACD is popular because of its ability to help quickly spot increasing short-term momentum which is helpful when creating your short-term strategies.
The MACD is calculated by subtracting the value for the long-term moving average from the short-term average. In MACD calculations, 12 and 26-day exponential moving averages are used. The MACD can be customized to fit any strategy, but the defaults are these 26 and 12-day periods. The result of this calculation is plotted on the graph. A signal line is plotted on the MACD chart by using a9-day exponential moving average calculation and works as a trigger for buy and sell points.
Reading the Sign
Crossovers
When the MACD falls below the signal line, it is a bearish signal. This typically means it may be time to sell. When the MACD rises above that signal line, it is a bullish signal, and the price is likely to continue moving upward. It is a safe strategy to wait until the MACD has risen above the signal line for a short period to avoid jumping into position too early. Otherwise, it could dip back below the signal line quickly which is a common market correction.
Divergence
Divergence refers to when the two 12 and 26 days exponential moving averages begin to move apart. What this really means is a price low is not accompanied by a low of the MACD. This situation usually signals the end of a trend.
Rising Dramatically
When the short exponential moving average pulls away from the long-term version, it will show as the MACD rising drastically. This tends to be a sign that the cryptocurrency has been overbought but will return to normal levels soon.
Position to the Zero Line
Another signal to watch for is the position of the MACD in relation to the zero line. The zero line is often shown by a solid horizontal line on the charts. It represents the long-term average and acts as a support or resistance level. Upward momentum is represented by the MACD moving above the zero line meaning the short-term average is above the long term. Reverse this situation, and a downward trend could be forming.
Relative Strength Index (RSI)
The relative strength index (RSI) shouldn‘t be confused with relative strength which compare‘s the performance of a coin‘s price to the overall market average. RSI is a tool you can use to figure out if a coin has been overbought or oversold
which can provide you with entry and exit signals. It can also help spot or confirm reversals through monitoring for divergences. It is a momentum indicator that measures the speed and change of price movements. Values move back and forth between 0 and 100.
When the RSI goes 70 or above, it indicates the coin has been overbought or overvalued. If it goes 30 or below, then it has been oversold or undervalued. In both situations, it is vulnerable to a trend reversal. The default time frame for comparing up periods to down periods is 14 trading days.
The RSI is also used to spot divergence. When the price is rising, but the RSI is falling, this is known as a bearish divergence. When buying momentum is slowing like this then this is a warning that the price could soon correct lower. Bullish divergence is when the price is falling, but the RSI is rising. It warns the price could soon move higher since selling momentum is slowing.
Each coin will move differently and could have different ranges. When you notice the pattern, adjust the level to suit the movements. This could mean 40 may be a better entry point than 30. False buy or sell signals can happen in the RSI if there are sudden large price movements. To offset this issue, some traders use higher and lower values such as 80 and 20 as buy or sell signals. However, it is very important to use other technical indicators to confirm your predictions when using the RSI indicator.
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Simple Moving Average and Weighted Moving Average
There are several types of moving averages, regardless of the type, they are all considered to be lagging indicators. Lagging indicators are all based on what has already happened while predictive indicators help us figure out what might happen in the future. Based on this information you may think they aren‘t very useful. This isn‘t true; they can be used to determine the strength of a market trend as well as help decide between actual market reversal points and common rate fluctuations. Only 3 are commonly used by traders. These are the simple moving average, the weighted moving average, and the exponential moving average. It will take some testing to determine which of the moving averages fits your trading style. We recommend you start with the simple moving average based on the last 20 prices.
Simple Moving Average
The simple moving average is calculated by taking a set of prices, adding the prices together and then dividing the total by the number of data points. It is the simplest form of moving averages. This is calculated in a way to move in response to the most recent data that was used. If you choose to include 20 of the most recent exchange rates, then the oldest will be the rate to drop out of the calculation when a new price takes effect. As each new price is included, the oldest one drops, this calculation type ensures that it is only based on the most recent 20 prices.
Weighted Moving Average
A weighted moving average is calculated in the same way as the simple version. The only difference is this calculation uses values that are linearly weighted. So, the oldest rate in the calculation would receive a rating of 1; the next oldest would receive a 2, and so on until the most recent rate. This ensures that the most recent rates have a greater impact on the average than the oldest. Some traders find this method more relevant for trend determination, especially in a fast- moving market. However, there is a downside. The average line that is created could be more ragged than the simple moving average version. This means it could make it more complicated for you to figure out if a trend is happening or just a fluctuation. Solution: you can use both versions on the same price chart to see how they line up.
Exponential Moving Average
Just like the weighted moving average, the exponential moving average is similar to the simple moving average. The difference between the two is the simple moving average will remove the oldest price when the new one is in effect. An exponential moving average calculates from the starting point you choose the average of all the historical ranges. Let‘s go back to our initial range of the last 20 prices. The first calculation you receive will be identical to a simple moving average because there are 20 prices (or reporting periods). This is where an exponential moving average differs. When a new price becomes available, instead of taking the most recent 20 as with the simple average, you will now have the average on 21 reporting periods. As new prices take effect, they are included in the total pieces of data used to find the average.