Fundamental Analysis vs Technical Analysis in Crypto Trading

Fundamental Analysis vs Technical Analysis in Crypto Trading

Table of Contents

While the cryptocurrency market is relatively new, traders use the same old methods to anticipate the next price movement. There are two main analysis approaches or school of thoughts in trading – fundamental analysis and technical analysis

You might be familiar with these methodologies from the foreign exchange and stock markets, but how do they work with cryptocurrencies? And more importantly, which of these analysis approaches does work best for crypto assets like Bitcoin? In the following lines, we’ll compare the two concepts, but first, let’s describe each of them separately in a nutshell.

What is Fundamental Analysis?

Fundamental analysis is a method employed by investors and traders to figure out the intrinsic value of an asset. It has to do with the monitoring of relevant economic and financial factors that impact the asset’s value. For example, Bitcoin is currently trading at about $9,000 as of July 2020, but is this a fair price? Does the cryptocurrency deserve to be paid such a price, or is it undervalued? Fundamental analysts would try to establish this real price by analyzing the supply/demand ratio, the health of the ecosystem, adoption level, regulation, and many other factors.

Obviously, Bitcoin is way more volatile compared to most traditional assets, so fundamental analysts have a difficult job to anticipate the subsequent price moves by looking closer at the main news and events that influence investors’ sentiment. There are both internal and external factors that can have a say in Bitcoin’s price action.

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For example, think about the halving event that we described recently – this was a relevant internal factor that triggered a rally, at least most analysts agree on that. On the other side, we have impactful external factors like the coronavirus pandemic and the central bankers’ unlimited quantitative easing.

One of the key metrics to assess the current real value of Bitcoin is to monitor the mining difficulty. In the first years after Satoshi Nakamoto’s whitepaper, mining Bitcoin was quite affordable. In fact, it was so easy to mine cryptocurrency that one man accumulated about 7,500 coins and accidentally threw away the hard drive that stored the private keys. That fortune would cost almost $70 million today.

Besides mining, analysts are looking at any clues that point to the degree of adoption and interest from traders. We can check the number of digital wallets holding Bitcoin, the trading volume per a given period, the regulatory environment, etc.

What is Technical Analysis?

Unlike fundamental analysis, technical analysis is focused exclusively on the price action and nothing more. This type of analysis is attempting to anticipate future market behavior by looking into historical data such as volume, price action, and relevant information about the price. This method operates with tons of indicators built around the price of an asset. Besides indicators, there are certain patterns that precede specific movements, and there is the chart itself, which can be monitored in real-time by switching the timeframes and looking for clues.  

Technical analysis has become an integral part of cryptocurrency trading, as it helps traders discover potential trends and the perfect timing to enter long or short positions.

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The groundwork for the modern technical analysis is the so-called Dow Theory, a series of principles developed by American journalist Charles Dow. Born in 1851, Dow is the inventor of the popular stock market index Dow Jones Industrial Average. He also founded the Wall Street Journal (WSJ).

Thanks to the advancements in technology, technical analysis has become dependent on computers. There are special programs that can easily overlap any indicator on any price to check its past behavior.

The main supposition of technical analysts is that the price doesn’t move randomly but follows specific patterns based on the previous moves.

Traders who employ this method try to assess the intensity between the buying and selling forces, which are always in opposition. These forces are the reflection of investors’ sentiment.  

It’s worth mentioning that technical analysis works much better in markets that have matured and have high liquidity and trading volume. Conducting this type of analysis on lesser-known cryptocurrencies might not guarantee the desired outcome, as the price can be easily manipulated by insider traders.  

Fundamental Analysis vs Technical Analysis

If we’re talking about Bitcoin, the market is mature enough to effectively support both types of analysis – so which one is better? In fact, it is up to you to decide what approach works best for you. As a rule, long-term traders and buy and hold investors prefer to follow the news and monitor the global adoption of Bitcoin. Short-term investors rely on technical analysis to profit from price fluctuations.

In reality, the best approach would be to mix the two so that you don’t miss anything. For example, if you perform technical analysis on a regular basis, it would be reasonable to watch the news here and there so that the price couldn’t take you by surprise in a negative way. In a similar fashion, if you consider yourself a fundamental analyst, you can still check the chart and monitor the trading volume or other indicators to understand the market sentiment.

Even if the two analysis approaches are in stark contrast with each other, they are complementary. You can use fundamental analysis to grasp the general context that may shape potential trends. Once you understand the market direction, technical analysis can help you find the right entry and exit points.

In the case of lesser-known cryptocurrencies and tokens, you should never skip conducting some kind of fundamental analysis, especially if the token issuer provides specific services. You can start by assessing the project’s whitepaper, competition, roadmap, team, the use case, and so on. The market capitalization of such tokens is much lower, so technical analysis would make sense only to a certain degree. Most tokens tend to follow the general cryptocurrency market dominated by Bitcoin. However, they can also move independently if the blockchain business behind them is going through an upgrade, partners with relevant players, or introduces some kind of new product or service that catches investors’ attention.

For more popular tokens, e.g., Ethereum, Ripple, Cardano or Stellar Lumens, both methods should work as in the case of Bitcoin since the markets are mature enough. Some traders prefer to trade these tokens by using technical indicators alone. However, the so-called efficient market hypothesis (EMH), a theory that claims that it’s impossible to consistently beat the market by relying on technical analysis alone, argues that traders should not count on past data only. Proponents of this theory suggest that financial markets, including Bitcoin, reflect all known information about assets and that the current price already takes into account historical data. Thus, the main fluctuations happen primarily because of new data, most of which can be provided by fundamental analysis.

All in all, there is no better analysis method out of the two, as both can guide you in the right direction. What makes the difference is how skilled you are in applying any of those to your benefit.

Fundamental Analysis: Main Indicators

Stock traders operate with fundamental indicators like the earnings per share (EPS), price-to-earnings (P/E) ratio, price-to-book ratio, and so on. However, these measures are not applicable with any cryptocurrency out there. Instead, crypto traders employ other metrics, most of which are relevant for digital assets only. Here are some of these indicators that you should look into:

Network Value-to-Transactions (NVT) Ratio

similarly to a stock’s P/E ratio, the NVT ratio is calculated by dividing the network value by the daily transaction volume. The measure reflects a network’s value based on the value of transactions it supports. Let’s say that you analyze two crypto projects that have an equal capitalization of one billion US dollars. However, the former has a daily transaction volume worth $50 million, while the second project has a figure worth $10 million. 
Based on the mentioned formula, the NVT for the first cryptocurrency is 20 while the NVT for the second project is 100. As a rule, cryptocurrencies with lower NVT are considered undervalued while those with higher ratios might be regarded as overvalued.

Active Addresses

Some crypto traders check the number of active addresses on a given network to measure the level of adoption. While it doesn’t accurately reflect how much a token is really used, the indicator can show the network activity to a certain degree. You can use this gauge in combination with other factors when evaluating a digital currency.

Price-to-Mining-Breakeven Ratio

This is a metric for assessing cryptocurrencies whose blockchain relies on the Proof of Work (PoW) consensus mechanism. If you’re not familiar with PoW and Proof of Stake (PoS), you can read our recent article about these two algorithms. Back to our topic, the price-to-mining-breakeven ratio focuses on the costs associated with the mining process, including GPUs or ASIC hardware and electricity.

To find out this ratio, you should divide the current market price of a coin by the cost of its mining. The price-to-mining-breakeven ratio can offer valuable information about the health of a blockchain network. The breakeven is simply the cost of mining a coin – for example, if the cost is $5,000, miners would spend $5,000 to generate a new coin.

Let’s say that Coin A is priced at $4,000 and Coin B trades at $16,000, and both have a breakeven point of $8,000. The first coin’s ratio will be 0.5, while Coin B will have a ratio of 2. In this example, mining Coin B will be profitable, which will attract more investors and potentially boost the price thanks to increased demand. In the case of Coin A, miners may leave the network until the price doesn’t decline to the point when it’s profitable to mine.

Whitepaper, Team, Use Case, and Competition

As mentioned, the basic method to understand the value of a cryptocurrency or token is to do some research. This is especially true for lesser-known tokens. By simply reading the whitepaper, you can comprehend the project’s goal, approach, innovative product or service, and use case.

You should also check whether the founders or other team members are experienced at developing and scaling such products. If there is a roadmap, it will show you whether the project is growing in line with the initial plans.
Finally, you can go deeper and research the tokenomics, relevant partnerships, support from venture capital firms, regulatory environment, and so on.

Technical Analysis: Main Indicators

Technical analysis is all about indicators and patterns monitored on the chart. As a rule, traders use a combination of indicators to understand the state of the market and assess the trends. There are three possible trends: uptrend, downtrend, and sideways trend, which is a horizontal channel. Here are the most important indicators to consider:

Moving Averages

Moving averages (MAs) are the raw materials for many other indicators, as they help traders better visualize the trends. MA lines reflect the sum of close prices of a cryptocurrency within a certain period divided by the number of periods. The close prices can be replaced by open prices, lows or peaks. Also, there are more types of MAs, including simple moving averages (SMAs) and exponential moving averages (EMAs), which weights recent prices more heavily than the older ones.  

Moving Averages - Technical Analysis Crypto Trading
Moving Averages – Technical Analysis Crypto Trading. Example of SMA with period 20 (red line), and EMA with period 9 (blue line).

Relative Strength Index (RSI)

While MAs fall into the category of trend indicators, the RSI is part of so-called oscillators. This group of indicators shows the momentum of a trend, i.e. they show when a cryptocurrency is overbought or oversold. The RSI has a range that varies from 0 to 100.

Relative Strength Index RSI - Technical Analysis Crypto Trading
Relative Strength Index RSI – Technical Analysis Crypto Trading

Bollinger Bands (BB)

Bollinger Bands combines a moving average with two lateral bands that flow around it. It is used both as a trend indicator and an oscillator, as it helps traders assess the potential overbought or oversold levels. On top of that, BB can accurately show the volatility level during a given period.

Bollinger Bands BB - Technical Analysis Crypto Trading
Bollinger Bands BB – Technical Analysis Crypto Trading

There are more complex indicators that apply additional formulas to existing metrics. For example, the Stochastic RSI is another oscillator that derives from the regular RSI. Elsewhere, the moving average convergence divergence (MACD) is generated by subtracting two EMAs.

Besides watching for the trends, traders try to define the support and resistance lines, which are specific levels where the price tends to bounce back and stop its current trend due to buying or selling pressure. Fibonacci retracement is an interesting indicator that helps traders find the potential resistance and support lines.

Indicators help traders find the right entry and exit points, i.e. the ideal time to open or close long or short positions. In other words, they are looking for specific signals generated by indicators. For instance, when the RSI displays a reading of 70 or more, it points to an overbought level, so traders might consider going short or closing their long positions.

Note that such signals cannot guarantee that the price will follow a certain direction. Technical analysis gives you the narrative, but you should make the final decision based on many other factors and by applying risk management techniques. The cryptocurrency market is more volatile than the forex or stock markets, so the signals might not always work as expected.

Last but not least, traders are also looking for patterns on the chart, especially those formed by the candlestick chart type. Some of the most popular patterns are double tops, double bottoms, head and shoulders, triangles, and flags and pennants.

Source: Medium – Trading Chart Patterns – Technical Analysis Crypto Trading

The Final Note

Both technical and fundamental analysis have the same goal – to accurately assess the market conditions in an effort to anticipate the next price moves. Thus, you shouldn’t ignore one of these approaches and blindly follow the other one. As mentioned above, their effect can be boosted if used in combination. As CNBC analysts Rick Santelli put it:

“When I was an institutional broker in a former life, I was a believer in the merits of using technical analysis. I found that it was a very useful tool that complemented the much more mainstream tools generically referred to as fundamental analysis.”

Source: CNBC – Fibonacci Fate Date for a Bear Bond Market?

The important thing is to master each of these analysis methods and do a lot of research before making an investment decision. In the end, it is not the type of analysis that will generate profits but the way you trade. The cryptocurrency industry is growing at a rapid pace, and there are definitely many opportunities to look for.

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