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A Collection Of Strategies For Cryptocurrency Valuation And Price Signaling

|About: Bitcoin USD (BTC-USD)
Summary

An optimistically rational exploration of bitcoin investing.

Includes practical quantitative signals.

Discussion on amplifying returns.

Ignores all qualitative factors.

Introduction

There is nigh unlimited amount of information on the internet explaining to the masses just how blockchain and cryptocurrency works and the qualitative merits of its existence, however there seems to be a severe limit to the amount of information on how to determine the valuation and behavior of cryptocurrency in the context of an investment strategy.

Here I will collect everything I believe an investor would need to know to make a fast quantitative decision on investments in the cryptocurrency space. We will look at it in the following steps:

1. Asset Class Behavior

2. Valuation/Price-Signaling

3. Crypto-Asset Selection

Asset Class Behavior

First of all, there is no discussion on the subject of Bitcoins (BTC) volatility, which is the yardstick that all cryptocurrency investment performance is measured against. The extreme volatility of Bitcoin (shown in yellow) regularly exceeds that of other major asset classes (Gold, S&P500, EUR/USD)...

- Alpaca/Hackernoon

... and its beastly performance makes even the most highly leveraged version (TQQQ) of the highest risk traditional asset class (stocks) look like a anemic mouse by comparison...

... but the price we pay for this performance is its equally devastating draw-downs that have historically punished investors with 70/80/90% losses.

- Mark Decambre/Marketwatch

Coming to terms with these behaviors is not quite complete until one fully considers the mathematical implications of bitcoins performance as an investible asset.

Being a naturally un-leveraged asset, an investor can take on a fixed level of risk (maximum 100% loss) for hypothetically unlimited gains.

Bitcoin is not a CFD, there are no margin loans and there are no margin calls. It's just pure investment savagery.

Without timing, a dollar cost averaging strategy of just 100$ a month since inception would have grossed an investor $71 million at the time of writing, a return of 659,383% on a $10,800 investment. (Simulated here).

With timing an investor could have caught 27000%, 6000%, 1000% and 8000% rallies, for a cumulative 1,295,999,900%. Yes you read that correctly, avoiding draw-downs and selling at the peaks would have grossed an investor over a billion percent over 10 years.

To collect these gains one needs to buy exactly at the bottom and sell at the peaks. A, quite literally, impossible task... until now.

Valuation/Price-Signaling

There has been leaps forwards in the science of bitcoin analysis and signalling over time and here we will examine all the current practical techniques for making timing decisions in regard to buying and selling cryptocurrency.

Special Mention to Adam Tache for getting all these models in one place so we can accelerate our understanding, and to Willy Woo for creating his amazing interactive charts.

CVDD (experimental) by Willy Woo.

CVDD (Cumulative Value Days Destroyed) has historically picked the bottom of the market. When coins pass from old investor to new investor, the transaction carries a USD value and also destroys an amount of HODL time by the previous holder. CVDD is the cumulative sum of this value-time destruction as a ratio to the age of the market and divided by 6 million as a calibration factor.

BALANCED PRICE (experimental) by David Puell.

An experimental attempt at capturing Bitcoin's 'fair' valuation by measuring the difference between what was paid (realized price) and what was spent (transferred price). This is the on-chain kindred spirit to Delta Cap.

DELTA CAP (experimental) by David Puell.

The Realised Cap minus Average Cap. Market Cap has historically touched Delta Cap at market bottoms.

REALISED CAP by Coinmetrics.

The value of all coins in circulation at the price they last moved, in other words an approximation of what the entire market paid for their coins.

MVRV RATIO created by Murad Mahmudov & David Puell 

MVRV is [] the ratio comparing the two, i.e. MVRV = Market Cap / Realised Cap. It’s useful for getting a sense of when the exchange traded price is below “fair value” and is also quite useful for spotting market tops and bottoms.

MAYER MULTIPLE by Trace Mayer

[The] price of Bitcoin against its long range historical price movements (200 day moving average), the Mayer Multiple highlights when Bitcoin is overbought or oversold in the context of longer time frames.

It`s worth noting as the market becomes larger and less volatile, the peaks are becoming less exaggerated. This is because a 200 day moving average baseline is a static yardstick against an ever growing, more stable, Bitcoin market. We should recalibrate what constitutes the overbought/oversold extremes on this chart accordingly.

NVT SIGNAL (NVTS) is a derivative of NVT Ratio by Dimitry Kalichkin

This differs from Standard NVT Ratio which is simply the Network Value divided by Daily Transaction Value, and then interpolated using forward/backward moving averages to create a smooth line.

Provides more emphasis on predictive signaling ahead of price peaks.

Stock-to-Flow Modeling by PlanB

Stock is the size of the existing stockpiles or reserves. Flow is the yearly production.

The hypothesis in this study is that scarcity, as measured by SF, directly drives value. A look at the table above confirms that market values tend to be higher when SF is higher.

A statistically significant relationship between stock-to-flow and market value exists. The likelihood that the relationship between stock-to-flow and market value is caused by chance is close to zero.

Bitcoin sentiment by Sentix GmbH 

Sentiment reflects the emotions of investors. A high sentiment is typically a sign for bullish exhaustion, while a bearish sentiment offers opportunities to enter the market due to fear of investors.

Transaction Value Trend by BitInfoCharts

Transaction Fees Trend by BitInfoCharts

Google Trends Confluence by BitInfoCharts

Crypto Fear & Greed Index by Alternative.me

And finally, what would appear to be the granddaddy of all exit signals...

TOP CAP (experimental) by Willy Woo.

The average cap multiplied by 35. Historically has matched market tops.

Crypto-Asset Selection

Armed with the knowledge of Bitcoins incredible performance and a collection of signals to help time your investment contributions, you'd think the fun would be over. However this is not the case as something very weird occurs in the cryptocurrency market...

The correlation between most of the coins in the market is very high, a superficial look reveals the unmistakable relationship.

This is further confirmed by the 365-day correlation data:

Another feature of the market is that Bitcoin, for all its returns, is actually the lowest volatility cryptocurrency in the market. All the other 'Alt-Coins' have a much higher trailing volatility. This was apparent in the last cryptocurrency bull market where Bitcoin increased an impressive 8000% but was left in the dust by Verge's 500,000% increase over the same time horizon. Take this arbitrary collection of alts as an example:

This surprising combination of behaviors could potentially lead to an even more effective strategy of cryptocurrency investing. The question being, if we can model the price behavior of bitcoin, and want the best return for our risk (hypothetical 100% loss), then what cryptocurrencies should we buy?

Perhaps those with the highest relative correlation and volatility? This would give us those coins whose movements are most likely to move in sync with bitcoin while also giving us the highest returns!

A list of coins ranked by their combined correlation and volatility score (Volatility x Correlation = 'correl/vol') would give us the coins fitting this criteria. While this is certainly the furthest removed from what one could call a 'holistic' investment strategy, it would certainly give an investor access to the best return potential per unit of risk for this already hyper-risky asset class.

This approach could be combined with qualitative research to best isolate investors from 'dodgy' projects, giving them the highest chance of success.

Disclaimer: This article explores none of the exogenous risks involved in cryptocurrency investment such as government regulation. Investment in these types of assets is akin to speculation.

Disclosure: I am/we are long BTC-USD.