Cryptocurrencies as an asset class

A cryptocurrency is a digital currency, secured by a cryptographic algorithm that prevents double-spending and counterfeiting. Most of today’s currencies work on computer networks independent of central authorities such as governments or banks, eliminating the need for traditional middlemen and facilitating true ownership of funds and quick (almost instantaneous) transactions.

Even though they are named cryptocurrencies, they are not considered to be currencies in the traditional sense (though they are classified as commodities, securities, or even currencies). They are usually viewed as a distinct asset class and are theoretically immune to government financial manipulation.

By asset class, we are referring to the ability of the asset to hold value and have true use cases. The first cryptocurrency, Bitcoin, defined in a white paper that was published on October 31, 2008, has already proven its value-holding potential; its returns for the last 10 years have been positive, even with its high volatility. Its main use case can be considered fast and cheap transfers (through the Lightning Network) that work between any parties having a Bitcoin wallet, 24/7.

In this section, you will hear a candlestick story, followed by an overview of the different timeframes that traders use. We will also discuss the various market participants and how their trading affects the market, creating different types of markets, each with its own unique characteristics and trading style.

A candlestick story

Hey Siri, play “The Candlelight Story” by Tony Chen.

The God of Markets, Munehisa Honma, is said to be the creator of candlestick charts. He was a rice merchant from Sakata, Japan, who traded the Dojima Rice Market in Osaka, during the Edo shogunate. Stories are told about when he created a personal postal service (men spread every 6 kilometers over 600 kilometers) to get the market prices in time. In 1755, he wrote the first book on market psychology, San-en Kinsen Hiroku, or The Fountain of Gold – The Three Monkey Record of Money, in which he talks about traders’ emotions and how they influence prices.

In 1991, the candlestick appeared in the Western world in a book called Japanese Candlestick Charting Techniques, written by Steve Nison, who says that, according to his research, it is unlikely that Honma used candlestick charts.

So, the initial story might actually be the first trading urban legend in Japan.

But what is a candlestick chart?

Well... let’s first start with a candle...stick!

Figure 2.2 – A candlestick

A candlestick chart is a financial chart that shows the price movements of securities, derivates, or (crypto)currencies. It is also called a Japanese candlestick chart or a K-line chart. Each candlestick there represents four essential pieces of information: the price at opening time, the price at closing time, and the lowest and highest price of that timeframe. They are usually colored white or green for rising prices (Close > Open) and black or red for falling prices (Open > Close).

Note

All images in this book are in grayscale, so there may be a slight adjustment period when you view the colored candles on TradingView.

So, with just one look, you can see if the price is rising or falling, by how much, and even what were the highest and lowest points it traded during that timeframe.

Here’s how it looks on a chart:

Figure 2.3 – A candlestick chart

This chart is also called an open-high-low-close (OHLC) chart (because you can see these values for each candle on the chart). To make it easier, we’re going to use the short forms for Open, High, Low, and Close (O, H, L, and C).

Here, you can see how the white candles (or green candles) show rising prices (C > O, meaning that the close price is greater than the open price; basically, it closes “higher”) and the black candles (or red candles) show falling prices (O > C).

Each candle on this chart represents 1 hour of price movement, and we’ll find out in the next section what exactly these timeframes are.

Timeframes

We know what a candlestick is and what a candlestick chart looks like, and now it’s time to understand how to represent price movements over large (or small) periods. Have a look at the graph shown in Figure 2.4:

Figure 2.4 – The Bitcoin Liquid Index (BLX); each candle is 1 month (logarithmic display)

In stocks, you can have gaps between candles because markets can open at different prices than when they’ve closed, but this doesn’t normally happen in crypto. Here, the market trades 24/7, so when you trade you can expect the close of one candle to be the price the next candle opens with.

Then, if a candlestick shows the OHLC values, the distance between the opening of one candle and the next opening is the time length of the candle. Based on how we configure the chart, we can have anywhere from 1-second candles to 1-month candles (and more).

A 1-hour candle starts at :00 (minute zero) and ends at :59 (minute 59), and these candles are displayed on the hourly timeframe (also called the 1-hour timeframe or 1H). A 1-day candle starts at 00:00 and ends at 23:59 and is displayed on the 1D timeframe.

So, 1 candle on 1D equals 24 candles on 1H because there are 24 hours in a day.

Let’s check this out:

Figure 2.5 – A daily candle

The candle in the middle represents the price for BTC on July 7, 2022, in the BTCUSD market on Bitstamp. Its values are O 20546, H 21847, L 20238, and C 21644 (as explained in the section titled A candlestick story).

Let’s look at this candle in the 4-hour timeframe:

Figure 2.6 – A range of candles on the 4H timeframe

Here, the vertical bars show the start of each day. Starting from July 7, 2022, we have 6 4-hour candles until the next day. The last candle (black) is at 20:00, signifying the range 20:00-23:59.

The opening of the 1D candle is the O of the first 4H candle, at 20546.

The L of the 1D candle (20238) can be found as the lowest point in the range, at the L of the second black candle.

The 1D H (21847) and 1D C (21644) are both in the last candle of the 4H range.

If we draw a 1D candle over its 4H range, the result looks like this:

Figure 2.7 – The indicator used was HTF Candles by Prosum Solutions (author prosum_solutions)

Now, it’s time for you to play with TradingView and make sure you understand the different timeframes and how a higher timeframe (HTF) candle is composed of smaller lower timeframe (LTF) candles. In the next section, we’re going to talk about identifying the three types of markets that drive the cryptoconomy.

Market participants

All right. We have basic knowledge regarding timeframes now. But how does that help us trade?

Let’s consider the following types of key market participants:

• Commercials—insurance funds, pension funds, hedge funds, and institutions: Their main goal is protecting their capital using a portfolio profile, and for this, they can go where the market goes. The current price doesn’t matter that much (for example, they need to have a percentage of their portfolio in Bitcoin by the end of the quarter, no matter what happens to BTC). And their entries influence the price of the cryptocurrency being traded.
• Speculators—(manual) traders, algorithmic traders: The price matters; they consider the risk of their entries and trade market anomalies. Their entries don’t usually influence the price.
• High-frequency traders—bots and other automations: They do 90% of the trading, having well-defined entries and exits so that they can get the highest profit with the least risk. These entries influence the speculators because they both have the same short-term objectives.

The following are the types of traders:

• Scalpers: Scalpers trade quickly, based on order flow. Trades can take seconds or minutes.
• Day traders: They start and finish the day without an open position, trading based on technical analysis and order flows. They don’t care about the fundamentals of the cryptocurrencies they trade because they exit quickly. The trades take minutes or hours.
• Short-term traders: These traders use technical analysis, followed by some fundamental analysis, and their trades last for 3 to 5 days (for instance, they trade breakouts).
• Intermediate traders/swing traders: They use a combination of fundamental analysis and technical analysis to trade. Their trades take days, weeks, or even months.
• (Big) Long-term investors: They use fundamental analysis, and usually, filling their orders takes time (days even). Their moves influence the market, and they start and stop trends with their entries and exits. They stay in trades for years.

In order to simplify the mentality we should have when trading, let’s imagine we have a smart opponent that we’re trading against. When we win, they lose; when we lose, they win. They can wear different hats at different times—sometimes the hat of a commercial; another time the hat of a day trader.

The question we should always be asking ourselves is this: Which of the hats are they wearing in the current market conditions? Now, I’m going to give a few examples, but if you’re new to trading, feel free to skip them now and come back later, after reading the book.

Here are some examples of situations, but remember that any interpretation is relative to the truth:

• If we see a big upper wick on a 1-second timeframe on a specific exchange (and not on other exchanges), we can consider this to be a big one-time exit that reflects the needs of a commercial and doesn’t necessarily reflect a trend in the market. Basically, someone sold a lot of currency there, and then the market participants corrected that move by buying the orders back. But if we see multiple wicks, we can presume someone is continuously selling at that price a very large order by splitting it into small orders. There, we can expect more selling pressure than when a single wick forms. Here’s an example:

Figure 2.8 – Big upper wick

• If a cryptocurrency continuously trades in a price range, moving to the top, falling back, rinse, and repeat, that might be a situation where automatic algorithms are feeding themselves in a loop. If we spot these in time, we can enter longs (long trades) when the price is low, sell at the top of the range, and enter shorts (going short or shorting) until the price comes back down. Here is an example (but a low volume one) with an 8% increase and decrease in price, with each candle being 1 hour. Just imagine trading that:

Figure 2.9 – Steady price range

• Key news announcements in crypto create market volatility. A lot of speculators are trading at that point to profit from the volatility, specifically commercials that want to execute big orders. They are trying to find the liquidity that they need to sell their orders to:

Figure 2.10 – Fed press conference impact

All of these moves are influencing the trend, making the markets go up, down, or sideways. Let’s see how that looks in the next section.

Types of markets

Markets can go up or down or they can stay in a range. We call these markets a bull market, a bear market, and a sideways (or ranging) market.

Here’s what they look like:

Figure 2.11 – A bull market

A bull market represents a period (months or years) when the price of an asset appreciates over its historical value. If the period is smaller than a few months, it is named a bullish trend.

A bull market is characterized by the following:

• Positive news (called bullish news)
• A lot of big investments
• Money is thrown around (even in mediocre businesses)

You can’t usually identify the start of a bull market until you’re already in it.

Most people start trading during bull markets because that is the time when everybody is bombarded by optimistic news and the economy is strong enough that everybody has some money left to invest. But the problem is that latecomers are joining in right at the peak (or end) of the bull market.

And then, the bear market comes. Here’s how it looks:

Figure 2.12 – A bear market

A bear market represents a period (usually years) when the price of an asset depreciates over its historical value. And, if the period is shorter, we can call it a bearish trend.

A bear market is characterized by the following:

• Negative news (called bearish news)
• Few investments
• No money in the market or long periods without any big activity

After starting, newcomers are usually faced with a bear market where all the techniques that they’ve used to make money suddenly stop working. This is the point where they usually lose money and, after a while, leave the market.

When the new bull market comes, you will hear from them it’s all a lie, you’re gonna lose money, and other such things.

A sideways market, also called a lateral market or a ranging market, is a period when the price stays within a certain range. If the period is lower than a few months, we can call it a sideways trend. Here’s a sideways market on the chart:

Figure 2.13 – A sideways market

People don’t usually talk about sideways markets, and that is mostly because there is either no particular activity there or because the news is polarized, creating uncertainty. You can also see sideways trends during long bear markets where a lot of market participants have left the field.

But why do we call them bull markets and bear markets? Imagine how these animals attack their opponents. The bull thrusts its horns up, throwing its opponent in the air, while the bear swipes its paws down, pushing its opponent to the ground. Here’s a depiction of this:

Figure 2.14 – Bulls versus bears

If there’s an uptrend, we say that the bulls are in control, and when the prices are falling (there’s a downtrend), we say that the bears have taken control.

There are tips and tricks to trade each market, but for now, let’s focus on learning how to identify them. At the end of the chapter, there will be some exercises to help you do this.