As mentioned in an earlier lesson, one of the key trading principles is to “Know the market you’re trading.”
And knowing the market you’re trading in requires fundamental analysis (FA).
Fundamental analysis is especially important in the crypto market because crypto and blockchain technology is still nascent.
Not keeping up with what’s going on in the crypto market can be lethal for your trading capital.
Without doing fundamental analysis to screen out the weak crypto projects, you’re already setting yourself up for failure.
What is fundamental analysis?
Fundamental analysis (FA) is an approach used in financial markets to determine the “intrinsic value” of an asset, which is a fancy phrase for trying to come up with an objective measure of its worth.
The goal of fundamental analysis is to determine whether an asset is “overvalued” or “undervalued”.This is done by researching all the underlying information about a crypto project (its “fundamentals“) that’s available, such as the size of its user base, real-world applications, and potential future uses.
Other information that isn’t specific to the crypto market such as broad financial market sentiment, global economic conditions, geopolitical events, and regulatory risks are also considered.
All this information is taken into account and used to determine whether a crypto asset is “expensive” or “cheap” compared to its current market price.
The general assumption is that an asset will gravitate towards its “intrinsic value” over time, so if after performing fundamental analysis, you believe that the current market price should be higher (or lower), then there’s a potential trading opportunity!
For example, if you think a crypto asset is currently undervalued in the market because its future potential is not being fully recognized, you can trade based on your fundamental analysis and, in theory, make a profit.
How to use fundamental analysis
Using fundamental analysis is how I gather the information needed to understand the broad market environment and which assets make sense to trade in that environment.
Then I do a deeper dive into those assets I intend to trade and develop a directional bias (“bullish or bearish”) on its price, as well as identify whether or not there will be catalysts to push the price in your favor.
During this process, you should do your initial research on a crypto asset through the project’s whitepaper and official project updates.This shouldn’t be too tough to find as most legit crypto projects have an official website and/or forums, along with different official communication channels like social media (Twitter, Reddit), chat apps (Telegram, Discord), and blogs like Medium or Substack.
At a minimum, crypto projects should demonstrate:
- A unique solution to a real-world problem.
- A clear roadmap that includes a timeline of how the solution will be built.
- An experienced team of developers that are capable of executing the roadmap.
- Sound tokenomics (overall economics of a specific crypto asset such as how it will be allocated and distributed, how much supply will be created, incentives for holding it, etc.)
After you’ve done the initial research, you can then begin the process of tracking the project/token regularly. You should maintain routine checks of the media channels mentioned above (daily or weekly), as well as crypto news sites.
Don’t know where to start looking? Well, as with any other major life question here, Google search is your friend. Even a simple internet search can bring up news articles if there are any new ones on the day.
Also, get a gauge on broad crypto sentiment by checking out news and price action in the two biggest crypto assets: bitcoin (BTC) and ether (ETH).
Price action in these two markets tends to heavily influence the rest of the crypto space, so it’s a good idea to see what these two crypto “blue chips” are doing as well.
Finally, don’t forget to check in on top-level macro themes like global growth and inflation outlooks, monetary and fiscal policy outlooks from global central banks, as well as consumer/business sentiment data to get a feeling for overall market sentiment. Major geopolitical risks like war or pandemics may be worthy of note as well.
Take notes of the impactful events (i.e., strong market price reaction correlates with a known news event), your thoughts, and market behavior in a trading journal.
To help you get started, you can also check out our daily/weekly news and watchlist articles that we regularly post on BabyPips.com.This is not only a way to work through your understanding of the market’s sentiment or bias, but it also can be used as a reference tool down the road when working on trading adjustments or when working on your trade review. I’ll touch more on the trading journal later in a later lesson.
What is a trade idea?
After doing your research on the fundamentals of your target crypto, the crypto market, the broader financial markets, and identifying potential price catalysts, you’ll likely have enough information to develop a trade idea (or “thesis”) and your level of conviction on this idea.
A trade idea includes what your directional bias is on an asset (“Are you bullish or bearish?”), your rationale for being bullish or bearish, and how you wish to express this directional bias as a bet or trade (“Do you go long or short?”).
If you think you’ve found a potential trade idea, then a helpful exercise to help you develop it further is to answer the following questions (or any other questions you feel you need to ask):
- What is the dominant narrative or catalyst that will drive demand for this crypto asset or drive traders to sell it?
- How long could the dominant narrative on this crypto last?
- Has the narrative been fully priced in already? (For example, did a significant price move occur recently out of the blue for no apparent reason?)
- What upcoming catalysts could potentially change or support the market’s bullish (or bearish) sentiment on the crypto?
- Has the market seen this potential setup in the past? How did it behave then? Are there any differences between then and now?
- Does your fundamental analysis of a specific crypto asset align with the current crypto market sentiment? What about the broader global market sentiment? If not, are the drivers enough to overcome broader global market conditions?
With these questions, you’re trying to determine the most likely fundamental scenario to play out (two or more scenarios are a possibility), the most likely market behavior around your fundamental thesis, and if the broader market themes would help or hinder the price action in your asset.
The answers to the questions above will help you determine your level of conviction on your trade idea/thesis.
There are no hard and fast rules for determining your conviction level (unless you’re an algorithmic trader doing heavy number-crunching on large data sets to come up with specific probabilities); it’s more of a feeling that depends on how much fundamental work you’ve done, what your work says on the idea and your market experience.
Trade Idea Example: Poopoocoin (PPC)
As an example, let’s say you’re eyeing the crypto, Poopoocoin (PPC), a new utility token for a blockchain that claims way faster transaction speeds than other major blockchains.
They have a catchy slogan, “Poopoocoin is fast as sh*t!”
You’ve done a ton of reading and found that over the past year, it has attracted 100 new independent software development teams working on projects spanning DeFi, NFTs, Web3, and more. Also, its token supply is set to deflate after an upcoming network upgrade.
That’s a lot of positive narratives that’ll likely give it a 50% probability of token demand increasing, which would cause the price to rise right?
And what if a large institution was looking to buy and lock up 30% of the supply of tokens over the next quarter? That probably bumps up a bullish conviction even higher to a 70% probability of price appreciation from current levels, don’t ya think?
As you can see, it’s not an exact science, but it is a good practice to engage in and a necessary component of your analysis when determining when and how you want to deploy capital and manage risk later.