Decoding Cryptocurrency On-Chain Indicators
6
min read
In the dynamic realm of cryptocurrencies, altcoins have emerged as the favored choice for investors aiming to achieve higher returns compared to BTC or ETH. Unlike the relatively stable growth patterns observed with BTC and ETH, altcoins are known for their rapid price changes. Consequently, these investors aspire to capitalize on the market's volatility, aiming to secure greater short-term returns on their investments.
Nonetheless, many individual investors find themselves stumbling due to hasty decision-making. Making investment choices driven by market excitement rather than careful analysis can result in unfavorable results. A significant number of individuals succumb to the appeal of rapid gains, frequently purchasing assets when prices are at their peak due to a surge. This can lead to losses when the inevitable market correction takes place.
Above is a graph comparing the BTC market cap and the cryptocurrency market cap excluding BTC and ETH from November 2021, which marked the peak of the last cycle. The blue line represents the overall crypto market cap, while the orange line represents the BTC market cap. Following the significant drop, the market cap of the altcoin market has not recovered in comparison to BTC. This is a result of crypto-induced pump-and-dump scenarios rather than an organic increase in the market price of altcoins. In simpler terms, if you made an emotionally driven investment at the peak and failed to sell at the right time, you would have incurred a significant loss in your portfolio.
In this blog post, we will explore how to utilize data to adopt a strategic approach that enables investors to make well-informed decisions, all while deftly steering clear of the traps linked to emotional trading.
The price and trading volume represent the most fundamental and crucial data that investors can rely upon. VWAP(Volume Weighted Average Price) takes into account both price levels and trading volumes, offering a comprehensive view of market trends. Understanding VWAP data helps investors identify levels where price and volume align, enabling them to make informed decisions about entry and exit points.
Unlike a simple average, where each data point is given equal weight, VWAP assigns higher importance to trading volumes. This is crucial because trading volume reflects the actual activity and interest in the market. In other words, VWAP gives more weight to price points with higher trading volumes, capturing the essence of the market sentiment more accurately.
Why is VWAP important for altcoin investors? By looking at the VWAP, investors can identify levels where price and volume align, indicating potential support or resistance levels. These are the points where the market sentiment is particularly strong. If the price crosses above the VWAP, it may signify a bullish trend, while a drop below could indicate a bearish trend. In essence, VWAP acts as a sort of "fair value" indicator by considering not only the price but also the market's collective opinion through trading volume.
The graph above serves as an illustration of BTC's historical VWAP. By computing the VWAP score from historical BTC price and volume data using rolling windows, and subsequently comparing the range bands using mean and standard deviation, you can determine the current price's relative position. If the current vwap score(red) surpasses the upper range band(black), one potential strategy involves selling using Dollar-Cost Averaging (DCA) in anticipation of an impending price decline. Conversely, if the current vwap score falls below the lower range band, a strategy could entail buying through DCA, expecting a potential price increase.
However, when it comes to altcoins, relying solely on the VWAP score as an independent investment indicator proves inadequate. Unlike BTC, most cryptos have a short history, leading to a likelihood of insufficient data for analysis.
Furthermore, even if a cryptocurrency enters the oversold territory, there remains a significant possibility of its price declining further without a recovery, or even facing the risk of disappearing through delisting. This aligns with the recommendation of implementing the PAA model for Bitcoin and Ethereum, as highlighted in the previous PAA blog post. If our previous blog post on PAA strategies interests you, please click this link.(https://www.moonbit.ai/blog-post/understanding-moonbits-protective-asset-allocation-strategy) Therefore, we need to look at additional data that can help determine the likelihood of an asset's decline reversing.
Futures markets provide additional data points beyond the spot market, such as open interest, and funding rate.
Open interest refers to the total number of outstanding contracts for a particular financial instrument, such as futures contracts or options contracts, that have not yet been closed or offset by an opposite trade. In simpler terms, when a trader initiates a futures contract, it results in an open position. This position remains "open" until the trader decides to either close it by executing an offsetting trade or by letting the contract expire naturally. The cumulative sum of all these open positions across the market is what we refer to as Open Interest.
Open Interest can be seen as a measure of market activity and participation. It represents the number of contracts that are actively being held by traders at any given time. A high Open Interest indicates strong market interest and participation, while low Open Interest might suggest limited activity.
Furthermore, monitoring both the overall volume of open interest and the specific open positions of market influencers can be beneficial in forecasting market directions.
This chart represents the net positioning of open interest across CFTC categorized as hedge funds of Tuesday's trading day close. Since this represents a net position, it is calculated as the total value of open long positions minus the total value of open short positions. In simpler terms, when the data is positive, it suggests that hedge fund managers' long positions are prevailing, which may indicate an anticipated price increase. Conversely, when the data is negative, it suggests that short positions are prevailing, implying a bet on a price decrease.
Hedge fund managers established the largest short positions in April and November 2021, indicating their bearish outlook. This alignment perfectly corresponds with the two peaks in BTC price. On the other hand, in January 2023, when the short positions are diminished and the net position approaches zero, we can observe a BTC price rebound from the previous downtrend.
For altcoins except BTC and ETH, there is no regulated CME futures market, but offshore exchanges operate futures markets such as Binance and Kraken. The actual demand of altcoins is often limited, giving rise to the phenomenon known as 'wag the dog,' where the impact of the futures market exceeds that of the spot market. As a result, by closely observing futures market data, it becomes feasible to anticipate when periods of price volatility are likely to arise.
Crypto exchanges provide both perpetual products and term futures. The significance of monitoring perpetual market data lies in its substantially higher trading volume when compared to other products.
A perpetual market, often referred to as a perpetual swap or perpetual contract, is a type of trading instrument offered by many cryptocurrency exchanges. It's designed to mimic the trading of futures contracts, but with some unique features that make it distinct. Unlike traditional futures contracts that have expiration dates, perpetual contracts don't have a fixed expiration. They're designed to be open-ended and perpetual, allowing traders to hold positions for as long as they wish. Perpetual contracts are designed to closely track the spot price of the underlying cryptocurrency. To achieve this, they incorporate a mechanism known as the funding rate.
The funding rate is a critical component of perpetual markets. It's a periodic payment exchanged between traders who are holding long positions and traders holding short positions in perpetual contracts. The funding rate ensures that the price of the perpetual contract remains closely aligned with the underlying spot price of the cryptocurrency.
Here's how the funding rate works:
The funding rate is typically calculated and paid periodically, often every eight hours. Its purpose is to prevent significant deviations between the perpetual contract price and the spot price. Traders who hold positions in perpetual contracts are either receiving or paying these funding payments, depending on market conditions. In straightforward terms, a negative funding rate indicates dominance of short positions, while a high funding rate suggests dominance of long positions.
Let's delve into an example. The graph above depicts the INJUSDT price, open interest, and funding rate of the INJUSDT Perpetual product on the Binance exchange. The contract's funding rate consistently remains below zero on the graph, indicating a dominance of short positions. Notably, on August 18, the funding rate rapidly dropped to -0.22% and then rebounded. This suggests a possible increase in long positions or a decrease in short positions. Simultaneously, the open interest data also witnessed an increase, implying a rise in long positions. Correspondingly, the INJ price during this period displayed a rebound. In essence, this analysis indicates that a local low might be formed at the point where the downtrend of the funding rate turns around and open interest increases. Conversely, on the 19th, as open interest declined, the price of INJ similarly fell once again.
Data from both the spot and futures markets is readily accessible for individuals keen on delving into the intricate mechanics. Nonetheless, for those who lean toward entrusting their investments to a team of professionals, or those who lack the time or expertise for autonomous strategy implementation, we're here to offer our assistance.
©Moonbit is the trading name of Moonbit LLC, a company registered in Hungary, Budapest.
© 2023 Moonbit LLC
.jpg)
