A happy or euphoric Bitcoin is characterized by three things :
The network is in good health (good Hashrate, lots of active addresses…);
The economics of participating in the network is rewarding (transaction fee, mining reward,…);
The economics of investing is healthy (realized cap/Thermocap, people in profit, Hodler activity,…).
Any small disturbance of this fragile equilibrium usually creates a chain reaction that has the chance to put Bitcoin on its knees. For example, each halving event (where the reward for miners is cut in half), affects layer 2 (the participation economics) instantly. This creates a rapid negative impact on layer 1 (the hashrate drops since some people disconnect their old mining rigs as it is no longer economically viable) that then causes a positive feedback on layer 2 (less competition for the existing miners, means better mining rewards) and then layer 3 (scarcity in miners to process transaction fees means scarcity in coins, driving up the price) . And so a new Bull run is born.
Another example is how China banned crypto mining in May 2021, resulting in a massive disconnection of miners, which immediately affected layer 1 (and layer 3 with fear), creating an earthquake on both upper layers. A brutal shock on layer 1 usually ends up turning rapidly into a good rally. This is what we saw happening at the end of July 2021, probably the most unique run that Bitcoin has had. It was mostly driven by the propagation wave of the dip on layer 1 into layer 2, but this time without much participation of new market investors (layer 3). The Christmas 2017 meltdown was primarily driven by the meltdown of the layer 3, which was becoming very unhealthy, and thus affecting the two other layers.
The relationship between all the different components of the blockchain ecosystem could be a whole discussion (or book) in itself, but the main takeaway here is that Bitcoin is a fragile ecosystem where corrections can unfold in many different ways. Monitoring on-chain metrics can give us access to the health of these 3 fundamentals layers (Cathie Wood’s Crypto team has a slightly different representation than us, but we both follow the same basic principles). However, the main issue is that there are literally hundreds, if not thousands, of different metrics/dataset out there that relate to these layers, so finding and correctly leveraging the right ones is quite the challenge.
Our indicators and the importance of redundancy
Early in 2021, Jennifer Kwiatkowski (who is one of the best AI researchers that I had the chance to work with during my career) and I, started to crunch all this data. We initially spent months building code that automatically analyzed all existing metrics (literally almost all) to see what they can tell us about different key events such as Bitcoin top, Bitcoin bottom, new bull runs, etc…
All this extensive work allowed us to find which on-chain data or metrics were the most relevant at describing any type of events in Bitcoins past. This led us to 13 incredible indicators that already existed (but that we couldn’t help tweaking a bit). But, with access to all this data we also could not resist jumping in and creating 8 new indicators. We think these ones are incredibly powerful and should continue to give a very reliable reading for the future cycles to come. Our Bitcoin strategy is based on these 21 indicators combined.
Twenty one metrics in a strategy seems like a lot, but we want to emphasize here how redundancy is important when trying to assess what is going on with Bitcoin. In 2021 we witnessed many people miss the cycle top by mostly using only one metric derived from the economics of bitcoin investors in a cycle that was not characterized by massive euphoria. Like we said above, the Bitcoin ecosystem is complex and although there are cycles that seem to repeat in time, each top and bottom have their own characteristics. Certain important metrics might vary much in a given cycle, but if a strategy monitors in many different ways all the 3 different layers of the blockchain ecosystem, the cyclical top should always be somewhat recognizable. In fact, all the tops and bottoms flagged by our strategy are usually the result of multiple metrics raising a flag.
Market phases as the cornerstone of our strategy
(it’s important because a different phase means a different behavior and a different risk.)
A key aspect of our strategy is that it uses several of our indicators to determine which phase of the market we are in. We called these phases the market bottom, the downtrend, the uptrend and market euphoria. This is a cornerstone of the global strategy as the behaviour of the algorithm changes depending on the current market conditions. The rationale behind this approach is that, firstly, each phase doesn’t have the same level of associated risk, and secondly, Bitcoin doesn’t behave the same during these different markets. For example, we found that during the uptrends that lead to euphoria, trying to consistently play the small dips along the road is nearly impossible. Indeed, like the example below, some of these dips happen suddenly but recover inside of 3 daily candles. Trying to sell there could easily result in a loss when going back in. Also, from the risk perspective, if we know that we are in a strong uptrend, there is not much risk associated with staying invested. Some people would even say that the risk in an uptrend is to not be invested, but we won’t go there since we think that money in the market is always money at risk.
During a cyclical downtrend, the strategy will tend to be out of the market (or short) for most of the time but will go back in momentarily to try to play the inevitable bear market bounces.
Not all these trades will be successful since this is usually not an easy environment to play, but the algorithm is set to be very sensitive in these market conditions and will quickly exit if it senses the downturn. Opposite to the uptrend, we think it’s highly risky to stay in the market during the downtrends.
The final drawdown phase is usually where we will re-enter the market. All the scenarios we have back tested in this type of market showed us that it is better to not be actively trading in this fear driven environment. In our strategy, we use several of our bottom metrics to try and re-enter close to the bottom. The algorithm will probably not pick the ultimate bottom, but the entry point is usually very close and it always ends up being a very rewarding trade not so long after. Here is an example of the entry point at the bottom in 2018.
The only other trades that the strategy will take in that zone is selling if after having bought the dip, we see the price action turning considerably negative. This is to keep a level of protection in case we see wild swings in that zone.
Another phase we consider is the beginning of a new uptrend. Historically, after hitting the bottom, Bitcoin has always had a long sideways trend or a minor uptrend for many months before re-entering into a meteoric rise. We found these zones consistently tradable for big movements. So the strategy will usually keep us in the market unless we see a big drawdown coming or an overheated market condition on some on-chain metrics. This phase usually leads to the euphoria phase, where we will start to tightly monitor our different on-chain indicators to see any sign of a top coming. When such reading comes we usually exit the market even if this means missing 2-5% of the final leg.
We will send real-time alerts to our Bitcoin Umbrella subscribers whenever our assessment of the market environment changes. The current market environment will always be displayed on the subscriber's member access page and will be included in our market updates/post.