When investors – institutional, professional or experienced retail – buy into a particular financial asset or derivative, they don’t do so blindly or on a hunch (or at least in the vast majority of cases). They make careful analysis of the current price level and the probability that it will rise or fall over the planned period of investment. We can break down analysis of financial assets into two main schools of methodology:
- fundamental analysis
- technical analysis.
Some investors and traders are staunch disciples of one or other of these two methodologies and ignore the other. However, many combine both.
What is Technical Analysis?
Technical analysis is based on the assumption that financial markets are inherently logical and the trading price of an asset has already taken into consideration all of the currently available information. It also holds that price direction moves in patterns, which repeat over time. Math based indicators are used to isolate the patterns currently forming on price charts and, based on historical data, forecast what is most likely to happen next.
What is Fundamental Analysis?
Fundamental analysis is based on the assumption that in the shorter term financial markets can be irrational and emotional and as a result often over or under value assets. However, in the longer term they will always return to, or close to, the intrinsic market value of the asset. Depending upon the asset or asset class, factors that contribute towards that fundamental value vary. Current supply and demand are key but other factors such as the fixed and variable costs attached to the asset and future influences on and prospects for supply and demand.
In the case of oil, for example, the main fundamentals are the cost involved in getting it out of the ground, market supply/deamand and OPEC decisions. In the case of a particular company stock there are more fundamental factors. Company’s revenues, expenses, product or services pipeline, record of innovation, management, the prospect of technology advances impacting their industry will all form part of fundamental analysis.
Is Technical Analysis Applicable to Crypto Trading?
There is a great deal of diverging opinion on whether either technical analysis or fundamental analysis can be effectively applied to forecasting the future price trajectory of cryptocurrencies. Most experienced technical analysts will say while there is value in applying technical analysis to crypto currencies, there are a handful of factors which limit how accurate it can be.
- The market is dominated by amateur traders with little to no experience of financial markets.
- Most crypto currency markets lack depth and liquidity, which means the actions of a few big investors can have a big impact on price direction and they are vulnerable to price manipulation.
- There is also very limited historical data against which technical analysis based strategies can back tested.
At least for now, the consensus opinion is that technical analysis has limited application in crypto currency markets but we don’t believe this to be the case. We believe that technical analysis applies to crypto like any other market and with increased liquidity has shown to be accurate. We recommend tools like BabyPips to get started in learning technical analysis.
Can Fundamental Analysis be Applied to Crypto Trading?
But what about fundamental analysis? Crypto currencies don’t produce revenue or other financial reportrs that would be used in the fundamental analysis of, say, Apple or Facebook stock. But neither does oil, copper or gold. Can a similar form of fundamental analysis as would be applied to commodities be used to assess the price trajectory prospects of crypto currencies?
Crypto Similarities to Commodities with Fundamental Analysis
In many ways crypto currencies are similar to commodities. In fact, they were designed with this in mind. Like extracting a barrel of oil from the ground, there is expense involved in the creation of a new crypto currency unit and verifying transactions over the peer-to-peer network of nodes. The computer processing power needed to solve the complex cryptography involved in the mining process of crypto currencies carries a cost in the form of computer hardware and electricity. This means that each crypto currency unit carries a fixed cost that should over the longer term mean a minimum price floor.
Crypto Similarities to Fiat Currencies with Fundamental Analysis
Perhaps fundamental analysis of crypto currencies is, then, more like that applied to traditional Fiat currencies? Creating Fiat currencies has much lower fixed costs than producing, extracting or mining physical commodities, though printing a note or minting a coin that is difficult to forge isn’t without expense.
Supply of Fiat currencies is also less predictable than is the case with crypto currencies, at least in the longer term, because central banks can print money if their monetary policy dictates. However, at least forward guidance is usually given on this policy so analysts can adjust their supply considerations based on central bank guidance.
Crypto Differences to Fiat Currencies with Fundamental Analysis
The difference between fundamental analysis of Fiat and crypto currencies at this stage of the development of crypto markets is that in the case of the former, demand is easier to forecast at least several months into the future. Demand for a Fiat currency is based on the success of the economy of the country for which it is issued. If the country’s economy is strong and has strong economic indicators such as employment rate and GDP growth, there will be strong demand for its currency domestically and abroad. If the economy is strong and the currency stable, there will also be increased demand for that country’s debt, with the bonds that represent that denomination in that particular Fiat currency. In the inverse scenarios, demand for those currencies will drop and so will their value in relation to other Fiat currencies for which there is increased relative demand.
What Drives Demand for Cryptocurrencies?
Key to effective fundamental analysis of crypto currencies is, therefore, finding a metric or metrics to accurately, or even very roughly, forecast future demand for the limited and predictable supply. And that’s the tricky part. The crypto market is developing so rapidly that predicting future demand for individual crypto currencies is akin to predicting how successful a tech start-up will be. Potential investors have to judge if the product or service addresses a real problem for the first time, in a way that is better than what currently exists or provides utility or enjoyment that will create demand.
In a similar way, crypto investors have to judge how successful they believe a particular crypto will be in attracting more holders and users.
- Currency coins: in the case of Bitcoin and other ‘currency’ coins, this would be a prediction of how likely it is that at some point in the next several years the particular crypto currency will be used as a means of value exchange to pay for goods and services as an alternative to Fiat currencies. Does this particular crypto currency stand a better chance of achieving that end goal than competitors? Or maybe it will become like digital gold and be held as a store of value? Either way, will there be more people buying, selling and holding it than at present?
- Utility coins: utility coins are different in that they are ‘spent’ to use a particular Blockchain platform. They can be roughly compared to the tokens you might buy from the bar or cash desk of an amusements arcade to use the pool table or electronic darts board. Prominent utility coins include coins attached to payments settlement system Ripple and coins like NEO and Ethereum.
In the case of utility coins it is slightly easier to monitor the number of users and traction their Blockchain ecosystem is achieving. However, like any new technology, accurately predicting the future adoption and size of user base is an inexact science.
There are numerous articles out there that explore fundamental analysis theories around crypto currencies. These include counting wallet addresses where these crypto currencies have been transferred into and out of, comparing the amount of Bitcoin in circulation to kilograms of gold and numerous other methodologies. Some hold a degree of logic and in the case of others it is highly questionable if much at all.
The reality is that the crypto market is in far too nascent a stage for fundamental analysis of mature, traditional asset classes to apply. The kind of fundamental analysis that can be applied is similar to that used when an investor judges the potential of a start-up. Does the crypto currency solve a problem? Does it solve it in a better way than competitors or does it have a strong market lead and/or brand that can be defended? What are future adoption prospects?