By Charles Phan, Chief Technology Officer, Interdax
Amid the confluence of powerful market forces it can be easy to get lost in the market ‘noise’ and be thrown off course in your trading strategies. But by complementing your technical and fundamental analysis, we explore a few simple measures that can help you navigate the market more effectively, allowing you to gauge sentiment and make better, more informed investment decisions.
Ultimately, keeping your finger on the pulse of the market will allow you to identify when extreme sentiment is dictating the direction of the market and is hence at a turning point.During these periods, there is no one left to take a bullish or bearish position and the existing trend is more than likely to reverse.
Given that the market is comprised of individual traders and investors, market direction is usually driven by the feeling dominant among the majority of traders. In such an environment how can traders best assess the overall market sentiment when trading cryptocurrency and adjust their positions accordingly.
Following cryptocurrency analysts, traders and investors on Twitter is one of the best ways to gauge sentiment and understand the mindset of market participants.. The large, active community of traders on Twitter post frequently about their views and opinions on the market, which should provide an overall understanding of market sentiment. Crypto analysts and traders also regularly post opinion polls which are a useful source in understanding which direction market participants think the price of bitcoin will go.
The impact of social media on bitcoin’s price has been widely examined in academic circles. A study by SMU Data Science Review found that the volume of tweets, rather than sentiment could predict the price of bitcoin, while another research article by the Association for Information Systems showed that the ratio of Twitter sentiment had a significant bearing on the bitcoin price in the short term.
A funding rate is calculated by how much a creditor receives for lending bitcoin to margin traders on exchanges like BitMEX, Bitfinex and Poloniex (Bitfinex also allows you to lend USD). Funding rates for cryptocurrency are often correlated with sentiment in the market.
For instance, if the market for digital assets is bullish, then the funding rates for USD should be higher than the funding rate for BTC, as people will want to borrow USD to go long on BTC. However, if the market for digital assets is bearish, then funding rates for BTC will exceed that of USD.
Sentiment indices are another good gauge of how market participants are feeling and one of the most popular is the Crypto Fear and Greed Index. Extreme fear in the market is represented by a value of 0 while a value of 100 depicts extreme greed.
To compile the Crypto Fear and Greed Index, several data sources are used:
- market momentum and volume,
- Twitter analytics,
- surveys from thousands of crypto investors,
- Bitcoin dominance, and
- Google Trends.
As shown above, the Crypto Fear and Greed Index closely tracks the bitcoin price. For example, the 2019 low for bitcoin hit approximately $3,300 on February 6th which corresponded with a Crypto Fear and Greed Index value of 14. Similarly, the 2019 high of almost $14,000 corresponded with an index value of 95.
Fundstrat’s Thomas Lee developed his own version called the Bitcoin Misery Index, but it is not freely available. A simpler version of a sentiment index is provided by Google Trends. As illustrated below, the peak in the Google search volume for the word ‘bitcoin’ correlated exactly with an all time high for the price of bitcoin in late 2017.
Zooming in we see that the search volume for bitcoin bottomed out near February 6th (when bitcoin reached its 2019 low near $3,300).
Websites and Twitter accounts dedicated to tracking ‘whales’ (traders that are very wealthy in terms of BTC) can also help with sentiment analysis.
Whales can often trigger large moves in the market and WhaleAlert enables you to see when these traders make transfers to exchanges, flagging large transactions using bitcoin, ether and litecoin (along with the address, the amount sent and where it was sent). These Twitter bots also track the minting of stablecoins, which have been shown to be linked with movements in the price of bitcoin. Another site that tracks cryptocurrency whales is WhaleWatch.io.
In 2018, the ‘Tokyo whale’ caused havoc by dumping bitcoins on the market several times to pay off creditors from the infamous Mt. Gox case. If you tried to long bitcoin while being unaware of the ‘Tokyo Whale’ and its effect on market sentiment , you would have ended up longing into large dumps, losing money in the process.
The weekly Commitments of Traders (COT) report includes data on bitcoin futures traded on the Chicago Mercantile Exchange (CME).
The COT report may not be as relevant now since the volumes of bitcoin futures is still low compared to retail-focused exchanges, but may become more useful as demand for the product evolves over time. Specifically, the COT report publishes Open Interest on bitcoin futures, which is the number of outstanding contracts at the end of each day.
Larry Williams, author of How I Made One Million Dollars Trading Commodities Last Year, used extremes in open interest to trade commodities.For instance, if there is an extreme reduction in open interest during a one- or two-day period and there are bullish indications present, then Williams would look to go long. Alternatively, if there is an extreme increase in open interest during a one- or two-day period and bearish indications are present, then you should look for an entry into a short position.
Another way to interpret the report is to look at what institutional investors are doing, since they have had a good track record in predicting the price of bitcoin. For example, institutional traders were net short on bitcoin futures in December 2017 as the cryptocurrency peaked and entered a bear market.
The COT report for Bitcoin futures is displayed above and can also be found on the CME website.
Accurately gauging market sentiment and keeping up to date with market trends is half the battle in executing successful trading strategies. By following some of the methods outlined above, cryptocurrency traders should be better prepared for navigating any seismic shifts in market direction or sentiment. Ultimately, the more access to information traders have, the more likely they are to be in making the most informed investment decisions.