Fundamental analysis, along with technical analysis, is one of the primary approaches to market analysis. Technical analysis focuses on analyzing prices and volume data of financial instruments. In contrast, fundamental analysis is a much wider field, encompassing financial and economic analysis as well as analysis of political trends.
Fundamental analysis of Bitcoin is an analysis of fundamental factors driving the supply of and demand for Bitcoin, as an asset. It is inherently linked to the examination of Bitcoin network and mining activities that measure Bitcoin’s global adoption and application, and, therefore, the global demand for Bitcoin.
Understanding what fundamental variables drive the demand for Bitcoin and how the Bitcoin price has been changing historically with changes in those driving factors will help investors and traders estimate a fair value of Bitcoin, and use it as a basis for making investment and trading decisions.
Bitcoin Valuation Model
In particular, over the period of the last 8 years, there was a strong positive correlation (linear dependency) between Bitcoin market capitalization and Bitcoin network activities, represented by the following three independent variables:
- Number of unique addresses used on the Bitcoin blockchain;
- Number of daily Bitcoin transactions; and,
- Hash rate of the Bitcoin network (i.e. total computational power of Bitcoin miners);
Linear Association between Bitcoin Market Cap and Variables of Bitcoin Network Activity
The following table presents correlation analysis, showing that there is a strong and positive linear association between Bitcoin market cap and variables of Bitcoin network activity, listed above. All correlation coefficients are positive and are close to 1.0 (strong linear association). This provides a statistical basis for applying a multiple linear regression model for Bitcoin valuation.
Scatter plots, presented in the following paragraphs, visualize the same relationship between Bitcoin market cap and each of the independent variables, listed above.
Exhibit 1: Bitcoin market capitalization and Bitcoin network’s hash rate
The data plotted on these graphs show a strong linear relationship with a positive slope between Bitcoin market capitalization and the Bitcoin network’s hash rate from 2011 to 2018. Hash rate reflects the aggregate power of mining hardware operating within the Bitcoin network. The correlation coefficient is equal to 0.96.
The economics behind this strong positive relationship is that an increase in Bitcoin market price makes the mining business more profitable and attracts competition, which leads to increased capital expenditures on mining hardware and, thus an increased network’s hash rate. Therefore, the actual data on the Bitcoin network’s hash rate allows evaluating the fair value of Bitcoin, consistent with historical dynamics between the two variables.
Exhibit 2: Bitcoin market capitalization and Confirmed transactions per day
The data plotted on the graph show a strong linear relationship with a positive slope between Bitcoin market capitalization and Confirmed transactions per day from 2011 to 2018. Confirmed transactions per day represent the number of daily confirmed transactions in the Bitcoin network. The correlation coefficient is equal to 0.94. The economics behind this strong positive relationship is that an increase in the number of daily transactions in the Bitcoin network is associated, by definition, with an increase in demand for Bitcoin. Increased demand leads to an increase in the Bitcoin market price. Therefore, the actual data on Confirmed transactions per day allows evaluating the fair value of Bitcoin, consistent with historical dynamics between the two variables.
Exhibit 3: Bitcoin market capitalization and number of unique addresses used per day
The data plotted on the graph show a strong linear relationship with a positive slope between Bitcoin market capitalization and the number of unique addresses used per day from 2011 to 2018. A number of unique addresses used are the total number of unique addresses used on the Bitcoin blockchain per day and is a proxy for the number of active users on the Bitcoin blockchain. The correlation coefficient is equal to 0.96.
The economics behind this strong positive relationship is that an increase in the number of unique addresses used is associated, by definition, with increasing global adoption and application of Bitcoin. This translates into increased demand for Bitcoin, which leads to an increase in the Bitcoin market price. Therefore, the actual data on a number of unique addresses used allows evaluating the fair value of Bitcoin, consistent with historical dynamics between the two variables.
Therefore, Bitcoin investors should closely monitor the changes in Bitcoin fundamentals, associated with network and mining activities. This will lead to making Bitcoin valuations that are more accurate.
Analysis of Bitcoin Futures Open Interest on CME & CBOE
What is included in the Traders in Financial Futures (TFF) report?
The Traders in Financial Futures (TFF) report, which is being published every week by the Commodity Futures Trading Commission (CFTC), is designed to provide transparency in futures trading on regulated US derivatives exchanges.
In particular, the TFF report discloses the total volume of concluded contracts in futures markets at a reporting date, known as Open Interest, and separates all traders in futures markets into the categories of Large Traders and Small Traders, based on their trading volume.
Additionally, the report disaggregates all Large Traders into the following four sub-categories: Dealers, Institutional Asset Managers, Leveraged Hedge Funds, and Other Large Traders. Then, for each of those categories, the report discloses the volume of both long and short positions being held at the reporting date.
Is the TFF report relevant to the Bitcoin market analysis?
As is well known, CME and CBOE – the world's largest futures exchanges – launched Bitcoin futures trading in December 2017, and the TFF report on Bitcoin futures trading is regularly published by the CFTC. Professional traders derive practical value from the TFF report by analyzing it within the following two dimensions.
Firstly, a trader should analyze the net position – net long or net short – held by each category of traders and the trend in changes in net position over time.
A significant positive net position in Bitcoin, held by a particular group of traders, means that the volume of long (buy) positions exceeds the volume of short (sell) positions, which implies that that category of traders is bullish on the Bitcoin and expect Bitcoin’s price to appreciate in the future. Conversely, a significant negative net position in Bitcoin, held by a particular group of traders, means that the volume of short positions exceeds the volume of long positions, which implies that that category of traders is bearish on the Bitcoin and expect the Bitcoin’s price to decline in the future.
Secondly, a trader should pay particular attention to analyzing the net position of leveraged hedge funds – a sub-category of large traders. The underlying reason is simple: Over the long-term, hedge funds are expected to generate a positive risk-adjusted return on invested capital. This is due to the fact that hedge funds are managed by professional asset managers, who invest significant resources in market research and trading strategy backtesting, are allowed to trade short, and are engaged in active trading.
Analyzing the net position in Bitcoin held by the leveraged hedge funds (large professional traders), and the weekly change in the net position, provides a sound and timely insight into the possible future trend in Bitcoin price. Thus, analyzing the TFF reports on Bitcoin futures is an essential analytical approach for Bitcoin's short-term traders and investors.
