Understanding How Cryptocurrencies Work: What Key Signs Should Investors Look out For?
Dmytro is a Founder of Solvid and Pridicto. His work has been published in Nasdaq, Financial Express, Kiplinger and Entrepreneur.
Why is Bitcoin worth so much more than other cryptocurrencies like Dogecoin? What causes coins to increase quickly in value whilst others decrease? There are virtually countless factors that determine the price and trajectory of crypto assets, so let’s take a deeper look into the key signs that investors should look out for.
When exploring the sort of analysis that underpins his cryptocurrency assessments, Maxim Manturov, head of investment advice at Freedom Finance Europe, suggests to consider a number of factors to help inform opinions regarding assets.
“When investing in cryptocurrencies over the long term, it is most worthwhile to be guided by fundamental analysis with criteria such as the amount of market capitalization, the number of coins in circulation, project visibility and reputation, the number of exchanges in which a coin is traded, asset volatility, and social activity,” Manturov suggested.
“In addition, you can use technical analysis, which will more accurately determine the entry into a position.”
When entering cryptocurrency for the first time, some investors make the mistake of picking low-price coins that are trending upwards in the mistaken belief that they could become as valuable as Bitcoin one day. However, due to the factors listed above, such price rallies are simply impossible for many coins.
With this in mind, let’s check out what factors like market capitalization and circulation can tell us about cryptocurrencies:
The Importance of Market Capitalization and Circulation
Market capitalization refers to the total value of a cryptocurrency - or asset. However, where stock market capitalization is assessed by multiplying a stock’s share price by the number of shares outstanding, in cryptocurrency, a market cap is worked out by multiplying the price of a cryptocurrency by the number of coins in circulation.
As the chart above shows, a coin’s market capitalization can reveal just how dominance an asset has across the market.
Here, we can see that Bitcoin is the dominant asset in the ecosystem. The coin’s market cap is found by multiplying the number of coins that’s been produced - which is currently over 19 million - by the price of BTC at the time. As the price of Bitcoin fluctuates, its market capitalization follows suit.
As we look at the world’s top 10 cryptocurrencies by market cap at the time of writing, we can see that there are major fluctuations between the circulating supply of coins.
Tellingly, the two highest value coins on the list, Bitcoin and Ethereum, have the smallest circulating supplies by some margin at 19 million and 120 million respectively. This fixed scarcity is a key reason why the assets’ respective prices are far higher than many of their counterparts. However, it’s also important to refer to the earlier chart which shows that both BTC and ETH are dominant coins in terms of investor adoption figures.
To further illustrate the importance of circulating supply, let’s look at XRP, which sits in 6th place among the world’s largest coins in terms of market cap. With 48 billion coins in circulation, XRP has flooded investors with coins, which can help to create more functionality in terms of spending the cryptocurrency in everyday situations, but it means that the coin’s price is $0.76 and extremely unlikely to see the values that BTC reaches due to its lack of scarcity.
However, this isn’t to say that it’s impossible for XRP to undergo significant price rallies similar to that of Bitcoin - it merely means that buying $100 of XRP today is unlikely to make you a millionaire tomorrow.
Finding Value in Reputation and Social Activity
It can be extremely difficult for investors to find key trend indicators in cryptocurrencies due to their highly speculative nature. For instance, as the world’s first cryptocurrency, Bitcoin is technologically inferior to many of its predecessors, whilst Dogecoin’s developers have long abandoned the token - making both largely free of fundamental indicators.
Instead, factors like reputation and sentiment play a major role in the blistering price rallies that we see throughout the world of cryptocurrencies. For this, investors must take to platforms like Twitter, TikTok, and Reddit to explore how others view their assets and whether a consensus is found on the potential future growth of a coin.
So vital is the influence of sentiment that a Bitcoin Fear and Greed Index has been set up on Twitter to offer insights into investor perceptions towards the cryptocurrency.
Reputation also plays a key role. For instance, in the case of the aforementioned XRP, Ripple was hit with an SEC lawsuit in late 2020 surrounding its status as a security. The uncertainty caused the coin to shed its value in a matter of days before recovering amid news that XRP’s status as a cryptocurrency was under no immediate threat.
Other governance issues among cryptocurrencies can lead to lawsuits and the actions of developers with bad intentions can lead to pump and dump schemes where the value of a coin is artificially inflated only for the developers to exit with their holdings, causing the price of the asset to plummet.
Rules of Thumb to Follow
For investors looking for more security in their chosen investments, it’s worth adopting a more cautious approach for assets that aren’t listed on many cryptocurrency exchanges. Because of the importance of reputation and stability, coins must pass rigorous vetting processes before they’re listed by leading exchanges - meaning that it’s unlikely that possible pump and dumps and ponzi schemes will be listed.
It’s also important to avoid highly volatile assets, because this may mean that unusually large trading activity is taking place with the coin. If a significant price rally takes place in a matter of hours, it can be tempting to dive in with the anticipation of more growth, but erratic movements of this nature are generally a bad sign.
As always, remember to stay vigilant at all times when investing in cryptocurrencies, and if an investment appears to be too good to be true, it usually is.
This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.
© 2022 Dmytro Spilka