Some newcomers to the blockchain industry believe that it is not affected by the emotionality of the general public. For some reason, the overwhelming presence of things like an AI crypto bot or auto-compounding platforms convinces outsiders and first-timers that price movements are dictated by robots and human emotion does not play a huge role in the direction and strength of assets.
Nothing can be further from the truth. The crypto market sentiment is a hugely important factor that must be accounted for when designing an appropriate trading strategy. While this particular phenomenon is caused primarily by activities performed by the participants of trading, it is still measured by technical indicators employed by experts. Tools like VIX, High-Low Index, or Bullish Index can help you identify the type of mood ruling the whole ecosystem.
Let’s talk about the influence of this phenomenon and how it can affect the outcomes of any investment activity. It is crucial to know when to panic and liquidate holdings or when to remain calm and keep DCA buying. The simplicity of the concept that we are going to discuss should not make you complacent and start thinking that you can largely ignore subtle changes that occur due to the shifting perceptions of certain digital assets, DeFi protocols, and even mainstream coins.
Understanding crypto market sentiment
The general vibe in the industry is often indicative of price action changes that may happen in the future. For example, if everyone is afraid that Elon Musk will make another tweet about the value of some weird unknown token, prices may be suppressed for a while until we finally get that new message on X. The public perception of financial instruments is even more important than many fundamental factors that can be completely ignored if people don’t have faith in them.
It works in both directions. Here are two illustrative examples:
- In 2022, the S&P500 index experienced significant volatility and one of the cruelest value drops since the 2008 financial crisis. The tumultuous period was caused by several factors including increasing interest rates and growing inflation. Despite companies in the index showing good results and even doing what they can to reduce losses by firing personnel, investors panicked and sold way more frequently than fundamental analysis would suggest.
- The current valuation of Tesla is still through the roof despite the Cybertruck fiasco. The market capitalization is above $690 billion (August 2024) despite EBIDTA declining three years in a row and revenues also falling year-to-year. People simply believe that Elon Musk can turn things around and take over the domestic electric car market by beating national and foreign manufacturers. Numbers say that valuation should be lower by several magnitudes, but investors have a different opinion.
These counterintuitive decisions by investors bring mayhem to the world of experts who rely on fundamental analysis to predict price action movements and determine the best course of action for portfolio adjustments. In many cases, the emotions and beliefs of retail traders and institutional investors simply go against common sense.
These two examples are obvious outliers. In general, people behave according to the expectations of analysts. If a company shows good performance year-to-year and improves its metrics, we expect its shares to go up. When the US treasury increases interest rates on their bonds, their value goes up and people start investing in them heavier.
The problem with the cryptocurrency domain is that most of the assets if not all are speculative. Many DeFi protocols, even those based on real-world assets, do not have anything tangible backing their operations. It means that people have to simply believe that the decentralized finance ecosystem works and can sustain itself. In some cases, this blind faith leads to spectacular failures like the one with Terra Luna.
Market sentiment and crypto prices
Opinions of large capital holders have a profound effect on the cash flow within the blockchain domain. It means that tracking certain wallet addresses becomes an important activity for investors looking for ways to adjust the compositions of their portfolios to make them safer. One of the most popular ways to do it is by being aware of crypto whale alerts that often indicate the mood of those whose decisions can sway the public in one way or another.
Whales are large capital holders controlling massive quantities of tokens on various protocols. Their decisions often have dramatic effects. For example, a whale staking thor funds on a lending protocol like Compound can easily remove their funds from a pool and reduce total value locked by a significant margin making other investors nervous and thinking about abandoning ship too. The same can happen to any liquidity mining pool.
Price action is subjected to the same principle with whales moving thousands of ETH and making users guess where all this money goes to. A movement of such quantities from a staking pool may mean that someone wants to liquidate their holdings which can drop prices and cause a massive selloff. If these funds are moved to a certain protocol, their valuation, TVL, and interest rates may go up causing investors to buy native or governance tokens from these projects.
It is incredibly important to keep track of such asset movements and analyze their potential impact on the industry as a whole and certain digital assets in particular. The role of market sentiment in crypto is hard to underestimate given the way it can be influenced by the opinions of social media personalities, celebrities, large investors, and experts.
You have seen this particular effect playing out multiple times in the history of the industry with so many infamous rug pulls and collapsing companies painting a colorful picture of the effect that emotions can have on market capitalization and trading volumes.
Sentiment analysis in crypto trading
Experienced retail traders know how to use it to their advantage by analyzing the current situation through the lenses of highly specialized indicators that tell you whether investors as a whole think that assets are oversold or overbought. Some experts use standard tools like the Relative Strength Index, Stochastic, Ichimoku Cloud, and others to make assessments of the dominant opinion. However, you can simplify the analytical process by employing some of the techniques below:
- VIX is the poster child of the whole opinions-of-the-traders-matter concept in technical analysis. Many people call the fear index as it analyzes options and thus the ideas of capital holders about the future. It is used for stocks that participate in the S&P500. When the indicator reaches high numbers, it means that investors are worried about the low values and may start buying. While it is useful primarily to those who work in tradfi, the general vibe of the national US economy has such a big influence on everything that you can gauge the overall mood of cryptocurrency traders too.
- The high-low index or HLI is a great indicator from the world of tradfi as it tracks stocks from companies that have reached highs and lows over a 52-week period. Depending on the value of the HLI, you can make an estimate of whether the current trend is bearish or bullish overall. The high-low index is also a tool that should be used only to assess the general condition of the US economy and how it can affect the prices of Bitcoin, Ethereum, and USD-pegged stablecoins.
- Moving averages are some of the most versatile instruments in the arsenal of a retail trader. These curvy lines can show the trend and its strength. While some prefer using MACD to gauge the same metrics, using three simple moving averages gives you more or less the same outcome. Moving averages can be applied to any price chart and can give you a good picture of what’s currently happening to digital assets.
- Crypto fear and greed index works like VIX but for mainstream coins like Bitcoin, Ethereum, Arbitrum, Polygon, and others. It is a great source of insight for investors looking for long-term strategies that can avoid losses from depreciation. If you are interested in any kind of active retail trading, using instruments like this one is hugely beneficial. You don’t have to look at it all the time, but when the time comes for an important long-term decision, check this index.
The importance of using specialized tools for the analysis of digital assets cannot be overestimated. The total market capitalization of the DeFi sector is quite volatile with people moving liquidity in and out based on their perception of the short-term performance of many protocols. It means that emotions rule price action and significantly influence decision-making. Without tools that help you determine the current mood of investors, entering the correct positions can be a challenge even for people with experience.
The emotional impact on crypto markets
Opinions of people with significant following can be incredibly influential and create short-term bullish and bearish trends. Established cryptocurrencies like Bitcoin, Ethereum, Tether, MakerDAO, and many others can withstand any storm of negative publicity. However, many younger platforms are subjected to the constant barrage of hopeful and critical takes from social media personalities, celebrities, politicians, and experts.
Social media in particular has been instrumental in price action changes within the industry over the whole of its existence. We all know the dramatic effect of a single tweet from Elon Musk that turned a meme coin into a global phenomenon and a surprisingly solid long-term investment for thousands of dedicated enthusiasts. We also know how a simple beef between the founders of FTX and Binance led to a massive collapse of the former.
It is true that emotions can have a great effect on the situation with all speculative assets like tokens. One of the emerging trends in market sentiment for crypto is analyzing the content of posts going viral on popular platforms like Instagram, YouTube, Telegram, and others. It is also a good idea to use Reddit and Discord with the sole purpose of looking at what diehard fans and enthusiasts are talking about.
Many people who become part of investor movements bringing down or pushing up digital assets are outsiders who do not have any knowledge about the industry. A survey by Preply among cryptocurrency owners showed that over 60% of people do not know anything about blockchain and DeFi with over 35% having concerns over the lack of education in this field. These people are an uninformed crowd easily swayed by opinions coming from perceived authorities.
Trying to “gauge the room” and understanding where the crowd is headed can be extremely useful to investors who want to capitalize on the significance of opinions and emotionality in the ecosystem. This method of gathering and analyzing information can be very time-consuming and requires you to keep in touch with several communities wasting hundreds of hours each month on tracking conversations, watching videos, and reading articles. Can it be rewarding? Absolutely! Can anyone do it? Not so much.
How can you use this concept?
Contemporary retail traders can use a variety of tools to improve their investment activities. Conservative investors may find it more appealing to engage in staking, liquid staking, yield farming, and other novel ways of allocating capital to the DeFi ecosystem. Proactive investors choose to work on an automated trading platform and run several bots that react to alerts produced by a technical analysis system.
The latter can be enhanced by the addition of crypto market sentiment analysis to the system. In many cases, adjusting the position sizes and choosing delayed orders can be improved by simply knowing what other retail traders think of the current situation with target digital assets. The idea is to keep stop-loss and take-profit ranges tighter during periods of uncertainty and fear-mongering in the community while increasing risks during moments when everyone appears hopeful.
When it comes to automation and other sophisticated approaches to retail trading, focusing on systems that can perform under all circumstances is a good idea. By understanding the importance of emotions in speculative environments, you can create methodologies that account for potential volatility and uncertainty. In some scenarios, simply running a DCA buying bot without liquidating holdings can be a good idea if the fear and greed index is low. On the other hand, complacency among capital holders may lead to moments when GRID or arbitrage becomes a more promising prospect.
We suggest following some basic rules:
- When fear is high and prices are falling across the board, it is a good idea to start acquiring assets for long-term holding. The whole process should revolve around reliable performers like Bitcoin, Ethereum, MakerDAO, and others. Tokens issued by DFi protocols may experience significant volatility even if they originate from popular projects like Uniswap or Compound.
- During periods when fear is low and greed is high, you should be focusing on alternative coins that have a big potential for price appreciation. For example, purchasing coins from blockchains that generate chatter on social media can be profitable. In the past, Cardano (ADA) and Polkadot (DOT) experienced short spurs of explosive growth. Now, we have Arbitrum, Polygon, Base, and Solana also enjoying the attention of crypto enthusiasts.
- Using investment techniques like staking or liquidity mining can be dangerous during bearish markets. One of the reasons is impermanent loss that quickly turns into permanent when prices continue falling across the board. The same can be said about using lending platforms like Compound or Aave where borrowing may slow down and APRs fall dramatically due to reduced activity.
Understanding how mood swings in the community affect price action is not as easy as it sounds or as we are describing it. The crypto winter of 2022 came unexpectedly after a sudden crash of the NFT domain with market cap and volumes experiencing a 90% decline over three weeks. The same is happening in 2024 with prices falling and many projects tightening their “belts”.
The main takeaway
It is quite a good idea to use various tools for crypto sentiment analysis to create robust portfolios and highly profitable approaches to trading. However, you should also remember that gauging the vibe in a diverse community is not as easy as it sounds. Be careful and use reliable techniques. Make sure to utilize the power of sophisticated instruments like automated trading systems and yield farming. Build a balanced portfolio capable of withstanding the chaos that can be caused by fear and greed.