Fundamental analysis of cryptocurrency
Making profits with crypto trading requires certain skills. Choosing a strategy, evaluating trading instruments, and mastering technical and fundamental analysis come with practice.
Traders in the cryptocurrency market often use the same technical indicators for trading currencies, stocks, and commodities. Tools like the Relative Strength Index (RSI), Moving Average Convergence/Divergence (MACD), and Bollinger Bands are extremely popular in the cryptocurrency space. They attempt to predict market behavior regardless of which asset is being traded.
While fundamental analysis of cryptocurrencies is similar to the approach used in traditional markets, there are no such proven tools that could be applied to the valuation of digital assets. For proper fundamental analysis of cryptocurrencies, you need to understand what their value is based on.
In this article, we’ll explain some indicators of fundamental analysis you can use to evaluate digital assets.
What is fundamental analysis?
One way investors evaluate an asset is by performing fundamental analysis. They gather information about important factors such as the company’s financial health and its underlying value and use this analysis to determine whether an asset is over or underpriced. This information can then be used strategically to open and close positions.
Unlike fundamental analysis, technical analysts believe that it is possible to predict the future behavior of asset prices based on past performance. They look at candlestick patterns and indicators to make their predictions. Traditional fundamental analysts usually look at a company’s performance to determine its true value. They use indicators such as earnings per share and the price-to-book ratio. They may do this, for example, with several companies in the same niche to compare their investment prospects.
The problem of fundamental analysis of cryptocurrencies
Cryptocurrency networks cannot be valued from the same perspective as traditional businesses. More decentralized options like Bitcoin (BTC) are closer to commodities. But even with more centralized cryptocurrencies, such as those issued by institutions, traditional fundamental indicators can tell us little.
The first step is to identify strong indicators, which means those that are difficult to manipulate. For example, the number of followers on Twitter, Telegram, or Reddit may be a poor indicator because it is easy to create fake accounts on social networks or to buy followers.
Furthermore, no single indicator would give us a complete picture. We can check out the number of active addresses on the blockchain and see how it skyrockets. But that alone tells us little. It may be a person transferring money to themselves, using new addresses each time.
In the following sections, we will look at three types of cryptocurrency fundamentals: on-chain metrics, project metrics, and financial metrics.
- On-chain metrics
On-chain metrics are metrics provided by the blockchain itself. A possible solution is to get information from websites specifically designed to help you make investment decisions. For example, the on-chain analysis of Bitcoin at CoinMarketCap provides a wealth of information. Other sources include charts from Coinmetrics and reviews from Binance Research.
- Number of transactions
The number of transactions can be a good indicator of network activity. If you graph the number of transactions over specific periods, you can see how the activity has changed. However, as with active addresses, we can’t be sure that a person is not transferring money between their own wallets to make it appear that activity has increased on the chain.
- Active addresses
Active refers to addresses in the blockchain that have been used in a given period of time. There are several approaches to counting them, but one popular method is to evaluate both the senders and receivers over a chosen period, such as a day, a week, or a month. Some also examine the cumulative number of unique addresses, which tracks the total number of addresses over time.
- Network fees
Fees can show demand for block space. You can think of them as bids at an auction: users compete with each other to have their transactions quickly included in a block. Those who bid higher get confirmed (mined) faster, and those who bid lower have to wait longer.
This indicator is interesting for cryptocurrencies with a decreasing issuance schedule. Proof of work (PoW) blockchains offer block rewards. For Bitcoin, they consist of a payout for mining a new block and a transaction fee. Rewards for mining a new block are periodically reduced; in other words, they are halved.
If mining costs increase over time and the block subsidy is gradually reduced, fees should increase. Otherwise, miners will suffer losses and leave the network, compromising security.
- Computing power and staking amount
Blockchains use many different consensus algorithms — mechanisms for verifying transactions. Studying the data associated with these algorithms can be valuable for fundamental analysis.
For cryptocurrencies with proof of work, computing power (hashrate) is often used to indicate network health. The more computing power, the more difficult it is to execute a 51% attack successfully. The cost of mining is affected by the asset’s current price, the number of transactions processed, and fees. Of course, the direct costs of mining — electricity, hardware — are also important.
Proof of Stake is another consensus algorithm that works differently: users stake their own reserves to participate in block confirmations. The amount of stake at a given time can be seen as an indicator of interest.
- Project Metrics
While on-chain metrics relate directly to quantitative data on the blockchain, project metrics include a qualitative approach that considers factors such as team productivity (if any), whitepaper, and plans for further development.
Before you invest in a new cryptocurrency, check out its whitepaper. This is the term for a technical document with an overview of a cryptocurrency project. A good whitepaper should describe the purpose of the network and ideally the following points:
- Technologies used (is the source code open?);
- Intended use;
- Plans for updates and new features;
- Scheme for supply and distribution of the coins or tokens.
It is advisable to relate this information to discussions about the project. What are others saying about it? Do the goals seem realistic?
- Project team
If a specific team is building a cryptocurrency network, you should research their backgrounds to ensure they have the necessary skills and experience. If case if you can’t find the information about the team, check out the developer community. For example, if you look at the GitHub repository, how many contributors are there, and are they active? A cryptocurrency whose development has not stalled may be more attractive than one whose repository has not been updated in two years.
A strong whitepaper should provide an idea of the intended scope of the crypto asset. At this stage, it is essential to determine what projects it will compete with and what legacy infrastructure it will replace.
Ideally, you should also conduct a thorough fundamental analysis of these competitors. The asset itself may seem attractive, but if you apply the same indicators to similar crypto assets, it may be weaker than others.
- Tokenomics and Token Allocation
Some projects create tokens as a solution to a problem. The project is not necessarily unprofitable, but its token may not be very useful. Therefore, it is necessary to determine whether the token has real utility and whether the market recognizes that utility and value it.
Furthermore, check out how the funds are initially allocated. Was there an Initial Coin Offering (ICO) or Initial Exchange Offering (IEO), or could users earn them through mining? In the former case, the whitepaper should describe how much the founders and team will receive and how much will be distributed to investors.
By focusing on the allocation, you can get an idea of the risks. For example, if most of the supply is owned by a few parties, you can conclude that it is a risky investment because these parties can manipulate the market.
- Financial Metrics
Information about the asset liquidity, the project’s economy behind the coin, and protocol incentives can also be helpful in fundamental analysis.
- Market capitalization
Market capitalization or network value is the circulating supply multiplied by the current price. In theory, it is not difficult to issue a worthless token with a supply of 10 million units. If one unit traded at $1, the market cap would be $10 million. Of course, this is a biased valuation: without a strong value proposition, the token is likely to be uninteresting to the general market. In itself, it can give the wrong impression.
It is impossible to truly determine how many units of a particular cryptocurrency or token are in circulation. Coins can be burned, keys can be lost, or funds can simply be forgotten. So it is a rough estimate that tries to weed out coins that are no longer in circulation.
However, market capitalization is actively used to determine the growth potential. Some crypto investors believe that small-cap coins are more likely to rise. Others believe large-cap coins have stronger network effects and, therefore, more opportunity than untested small-cap coins.
- Liquidity and volume
Trading volume is an indicator of an asset’s liquidity. Different methods can be employed to measure it, and it shows how much was traded in a given period. Usually, the charts show the daily trading volume (in network units or in dollars).
Trading volume is crucial to evaluate asset liquidity. A liquid asset can be easily sold at its trading price. And a liquid market is a competitive market with many asks and bids, resulting in a tighter bid-ask spread.
The problem with an illiquid market is that it may not be possible to sell assets at a “fair” price. With no buyers willing to make a deal, you have two options: lower your asking price or wait until liquidity increases.
- Supply mechanisms
For some, the tokenomics behind a particular project is one of the most interesting features from an investment standpoint. The maximum supply, circulating supply, and inflation rate can help guide decisions. The number of new units created for some coins is gradually reduced, making them attractive to investors who believe that demand for new units will eventually exceed their availability.
Other investors see the severely limited supply as a long-term detriment. They worry that it will not encourage the use of coins or tokens, as users prefer to keep them. Other critics argue that this disproportionately rewards early adopters, while a stable inflation policy is fairer to newcomers.
There are a variety of indicators that can be used to develop a profitable trading strategy. The essence of fundamental analysis is to create a system that allows you to evaluate different projects. The more qualitative research we do, the more data we have to work with.
Fundamental analysis can provide invaluable insights about cryptocurrencies that technical analysis cannot. The ability to separate the market price from the “true” value of the network is an excellent trading skill. Of course, technical analysis can tell us something that fundamental analysis cannot predict. That’s why many traders combine the two.
Like many strategies, there is no universal guide to fundamental analysis. Hopefully, this article will help you understand the factors you should consider to improve your trading outcomes.