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The Next Phase for Cryptocurrencies: What to Look Out For

Posted on: 09 February 2018 , by: Darren Sinden , category: Market Review

Cryptocurrencies have had a turbulent start to 2018. As I write Bitcoin, Ethereum and Litecoin are all down by 40% or more YTD. What's more, much of those falls actually took place in a period that spanned a little over a week. The pace of that change should not surprise us as those same instruments showed explosive growth to the upside recently as well. But many investors and traders, particularly those who may have had their first forays into the markets via cryptocurrencies, do seem to have been shocked by the rapid reversal of fortune and have been left wondering how to respond appropriately to that change. 

The answer to that, of course, will depend on their individual circumstances but in this Analyst Insights piece, we hope to provide some guidance as to what may happen next and how traders could react to the next phase, whatever that may be. Traders new to the market and cryptocurrencies in particular, will likely find themselves in one of the following scenarios. 

I learned early that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again. I’ve never forgotten that. Jesse Livermore* 

A Stronger Focus on Market Sentiment

This group of traders bought into cryptocurrencies on their way up. They were no doubt impressed by the ten-fold growth in the price of Bitcoin between mid-July and December 2017. That kind of momentum is hard to ignore and if your timing was correct then it's likely to have been very profitable for you. However, if you were late to the game and bought in towards the top of the recent range, or failed to lock in running profits before they disappeared, then I am afraid the opposite will have been the case. They say timing is everything and this is particularly true when trading highly volatile assets.

Some traders will also have compounded their problems by concentrating their risk by:

  1. Placing too much of their risk capital (money they can afford to lose); or 
  2. Placing too much of their total net worth (money they cant afford to lose) into these assets. 

They may have thought that by exposing themselves to more than one cryptocurrency, they were diversifying their trading/investment strategy. But unfortunately for them, they overlooked the high degree of correlation between the different cryptocurrency assets. 
That highly developed and positive correlation has largely been driven by sentiment among cryptocurrency traders. For the avoidance of doubt, a positive correlation implies that a move in the price of instrument A will result in a move in the same direction as the price of Instrument B. 

As we noted in the eBook Bitcoin for traders published in the summer of 2017:

"Ironically for an innovation that relies on networks for its very existence, there is no direct connectivity (for Bitcoin) with other markets and therefore little opportunity to hedge or arbitrage that volatility away. Instead, it's all internalised."

This internalised volatility is itself directly correlated to investor sentiment, and one inevitably feeds into the other - not just for Bitcoin but across the wider crypto universe. In plain English, selling creates even more selling (negative sentiment), while buying creates more buying or positive sentiment.

Prices are never too high to begin buying or too low to begin selling. Jesse Livermore* 

Considering a Long or Short Entry From Here. 

Of course, you may not have traded in cryptocurrencies before or have closed long positions higher up or have traded on the short side successfully, but are now thinking that these assets may have fallen far enough. Before you jump into the market you should consider what the background noise is telling you. For cryptos, this will largely rely on the use of technical analysis which we will look at a little later on. But there are the methods we can use to keep us informed about fundamentals and sentiment around cryptocurrencies. One obvious fundamental we should consider is the use case for a cryptocurrency, i.e. what purpose does it or is it intended to serve? How might that be monetised and reflected in the value of the underlying asset? This question may seem more appropriate for holders of the physical coins, and it probably is. 
But as CFD traders, we are interested in fundamentals that can change supply and demand and in turn the underlying price of an instrument. 

For example, the sharp spike in the price of Ripple throughout December and into early January was driven by the idea that the Ripple payment protocol was being trialled and possibly adopted by some commercial banks and payment networks.
 
Yet no explanation was offered as to how that would be reflected or monetised in the value of the Ripple coin. 

As CFD traders we don't necessarily need to concern ourselves with an in-depth understanding of the fundamental details of any individual instrument. This is simply because our exposure is only to the rise and fall of its underlying price. We do, however, need to recognise what might happen if the music stops and when that is likely to be. In this sense, it's not dissimilar to the parlour game of musical chairs where you need to be preemptive and react quickly when it does. Ripple posted a high of $3.23 on the 4th of January, but then the music had most definitely stopped and the scramble for a chair began.

My suggestion is to track three or four trusted news sites or services that hail from both the crypto world and more traditional sources of market information. Follow these closely for clues about likely price direction. For example, news items about hacked exchanges and government crackdowns on cryptocurrencies are likely to be negative for sentiment and price.

Technical Factors

Cryptocurrencies may be a 21st-century innovation, but some of the mathematical and technical studies we can use to categorise their price action dates back hundreds of years. As far back as the 13th century in fact, through the use of the Fibonacci series, a numerical progression which reflects the proportions of the so-called golden ratio.

Fibonacci

The chart below is a four hourly plot of our Ripple CFD overlaid with a Fibonacci retracement study. The Fibonacci retracement is drawn from the high price point and identifies strategically important levels that are derived from the Fibonacci sequence at 61.8%, 50%, 38.2%, 23.6% and 0%, of the range, from that high price. Note that a 23.36% retracement line implies that the price has moved by -76.40% from the starting point. I.e. that move is equal to 100% - 23.6%.

Four hourly plot of our Ripple CFD overlaid with a Fibonacci retracement

Price moves tend to respect Fibonacci levels, and we can see that the 38.2% line provided both short-term support and resistance during the current retracement. The 236.6% line also offered support between the 23rd and the 26th of January. But neither of these levels were sufficiently robust to repel the downward momentum in the price. Instead, it appears to be heading inexorably towards the 0% or 100% retracement line, found at 49 cents per coin. However, there are no guarantees that even this level will halt the price slide. There is an old market adage that says “never try to catch a falling knife” which is good advice for obvious reasons. To avoid being wounded in these circumstances, we should always let the market tell us when it's found a bottom.

To help us do this, we can turn to another form of analysis that has ancient roots. In this case Candlestick analysis and in particular so-called reversal patterns that date back to 18th century Japan. We won't have time or space in this article to cover candlestick patterns in any detail, but we can highlight a key reversal pattern we can all look out for. The image below is a simplified version of such a candle pattern; the Hammer.  The red and blue arrows represent the direction price before and after the signal is posted. 

Candlestick Chart - Hammer

A Hammer is said to beat out a bottom on the price action and is formed during a persistent downtrend. Sellers who have dominated for some time run out of ammunition allowing the price to catch its breath and buyers return and test the water. Those buyers drive the price higher in the absence of sellers, and we finish the period towards the high. The Hammer is a powerful reversal signal, but it requires confirmation. The best confirmation comes in the form of a higher low in the subsequent candle. Remember, higher lows and higher highs are the building blocks of an uptrend. So if the new candle is drawn with a gap above the high point or price in the Hammer, the better it is.

Key Takeaways

  1. Diversify: If you open multiple positions in various instruments, make sure that it diversifies your exposure rather than concentrate it.
  2. Size your positions appropriately: Don't overtrade via a single position or cumulatively through several positions respect risk and the use of leverage. 
  3. Scale in Scale-out: You don't have to put your eggs all in one basket, nor do you or should you put all your funds into a position. At the outset of a given trade, for example, if you want a position in 5 Bitcoin why not break that into 5 separate trades? If you are going long, for instance, you can add to the position as the price rises, or perhaps add on a dip, if it's short-term. Conversely, you can scale out of a profitable position by breaking it down into smaller chunks, minimum trade sizes allowing of course. 
  4. Use stop losses: Always use a stop loss to help limit your risk. But be sure to place them at a distance appropriate to the instrument you are trading. If something moves three percent per day on average, then all a? one percent stop loss, in that instrument, is likely to achieve is to stop you out prematurely within that average range. 
  5. Avoid confirmation bias: Perhaps easier said than done. By reading widely and taking in opinions that oppose yours, you can test your assumptions, trade ideas and positions against those contra opinions. If you are still happy with your thinking, then proceed. You can learn more about how biases such as this can hold back your trading here.
  6. Remember you can square and reverse positions on big directional swings: CFDs were designed specifically to allow traders to trade long and short with equal ease. And to turn their positions around at significant points in the market. This means that you don't have to sit idly by as, when and if the market turns against you. Technical analysts often say the trend is your friend, by which they mean to go with the market direction rather than opposing it.
  7. Don't catch a falling knife or try to pick bottoms or tops: Even the best most experienced traders have no special insight into where markets will reach a peak or form a bottom. Instead, they use a variety of tools and indicators to alert them to the fact that the market may be approaching these points. But most of all they observe the order flow and price action around them, effectively the supply and demand within a given market or instrument. After all excess of supply, in the absence of demand, will push a price down. While, excess demand, in the absence of supply, will drive a price higher. The points at which a market turns are the points at which these forces reverse roles. 


*Jesse Livermore 1877-1940  was a legendary Wall Street trader whose life and career immortalised in the book Reminiscences of a Stock Operator. Livermore lived and worked in an age of great change and innovation and yet he knew that then the game might change, but ultimately the rules don't.

 

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