Last buy signal fired on the 3rd of December 2020.
Every year there seems to be a new favorite indicator for crypto traders to try and catch the bitcoin bottoms, right now, the bitcoin hash ribbons indicator has started to create some minor buzz.
Traditional financial assets have the great benefit of being much easier to analyze due to businesses’ fundamental nature. While digital assets such as Bitcoin are entirely different in every regard and there have been very few established fundamental valuations of the asset.
This explains why in the crypto space, you will find predominantly technical evaluations. This holds true to both retail traders and the majority of professional traders.
Hash Ribbons, on the other hand, provides us with an opportunity to try and analyze some fundamental aspects of Bitcoin.
In this analysis, we will take a look at what the bitcoin hash ribbons and a single simple moving average as a bottom indicator measure, how to read it and an evaluation of the historical buy signals.
What is Hash Rate
Hash rate is calculated based on the number of blocks mined by miners.
It is the speed at which one can complete an activity in the Bitcoin code. Higher hash rate means your ability to mine the next block increases.
View the hash rate here.
The difficulty to mine bitcoin is adjusted approximately every two weeks, this means that it will require higher and higher hash rate to be able to mine at the same speed as before.
This has also been utilized to attempt and identify miner capitulation. Since the bitcoin difficulty adjusts every two weeks, we have to wait before getting any information on the mining situation, whereas with the hash rate updates daily. This means in comparison to the bitcoin difficulty, the hash rate can be viewed as a leading indicator.
View the bitcoin difficulty here.
Bitcoin Price and Hash Rate Relationship
The Bitcoin hash ribbons indicator’s core concept is that there is a direct relationship between the hash rate and price. The thought is that the miners will reduce their bitcoin mining efforts when an opportunity to get better results elsewhere occurs, this can happen for two reasons:
(1) Bitcoin price has decreased
(2) Mining costs (electricity) has increased
Looking at a ten year period for Bitcoin, there seems to be a correlation between when hash-rates are bottoming alongside price to indicate a local or close to local bottom for the bitcoin price.
The capitulation of miners can be considered a better bottom indicator than retail traders calling it quits. They tend to be one of the last to throw in the towel, which has to do with that they have mining profits to help offset the costs and loss related to a bitcoin price dump.
You will find that the hash rates decline less than the price itself, for example, we can see a maximum drawdown of bitcoin in 2010 of a whopping 93%, while the hash-rate was ‘only’ experiencing a 53% drawdown.
As the price starts to recoup the hash-rate will very quickly pick up, thus it won’t have time to reach similar down-trends as the price.
The miners will have to react to the price and adjust how much effort they want to put into mining after bitcoin. The price tends to decrease in price faster than it increases, which allows the miners to more efficiently adjust to the upwards price movement more than downwards, most of the time.
Calculation of Hash Rate Capitulation With Single SMA
By using simple moving averages (SMA) on the bitcoin hash rate, we can easily visualize when the bottoms occur.
If the daily measured hash rate has been below the 50-day simple moving average for a minimum of 3 days, it will be viewed as miner capitulation. When the hash rate then breaks through the moving average and stays above, it will be identified as a buying opportunity.
It is also worth noting that this is not a frequent signal, it happens on average every 15th month.
Critique of Single SMA
Historically this has yielded excellent returns, close to 150% return on average if held through the present day, with diminishing returns these last years. The danger of using moving averages or mean reversion when it comes to exponentially growing assets such as bitcoin is that the results will almost always be impressive.
It also has two periods of terrible drawdown consisting of around 45% drawdown, this is improved by using two shorter moving averages, which we will look at next.
Introducing Multiple SMA – Hash Ribbons Indicator
You can view the indicator live on trading view here.
The hash ribbon indicator is entirely free to use and it is open source as well, so if you want to make adjustments feel free to do so.
The indicator script can be found here on tradingview.
Unlike the single SMA strategy, the Hash Ribbon works with two simple moving strategies, one 30-day moving average and one 60-day moving average. Just like the single SMA, it is also used to identify miner capitulation and possible bitcoin bottoms.
Once the 30-day SMA of the bitcoin hash rate crosses above the 60-day SMA, this tends to signal the miner capitulation’s end. Historically buying at these points have been very profitable.
Together with the 1-month and the 2-month SMA, the hash ribbon indicator system adds the 10-day and 20-day SMA to help give out buy signals when the recent buy trend momentum is more bullish. This helps to lower the average drawdown by around 2% historically.
How the Hash Ribbon works
The first thing that has to happen for a buy signal to trigger is miner capitulation. The process starts with the 30-day crossing below the 60-day, this will signal the start of the miner capitulation period. Once the 30-day crosses over the 60-day again, it will mark the end of the capitulation period, and a buy signal is likely to be near.
The final piece of the hash ribbon indicator is the 10-day and 20-day moving averages. Once the 10-day crosses over the 20-day SMA, it will finally signal that it’s time to buy.
Jul-20 broke the recent trend of declining returns by amassing 3 times the results as the previous buy signal.
Looking at the historical buy signals on the hash ribbon, there is no surprise as to why it has become favorable in people’s eyes, after all, we all love ‘good news’.
There are two things I want to highlight so you don’t get blinded by the very high average max gain to the peak.
(1) The max gain has steadily decreased to from Jan-15 until today, with no exception.
(2) We recently set a new max-drawdown, increasing the average significantly.
In defense of the hash ribbons indicator, the massive drawdown of 45% relating to the buy signal on Dec-19 happened after it reached its peak, thus I would recognize this as a valid buy signal.
Please note the absolute peak used for measurement, this can give skewed image due to a long time between signal firing and the absolute maximum being used.
Conclusion Hash Ribbons Indicator
Much of the same critique given to the single SMA hash rate can be applied here as well. Bitcoin has historically been experiencing unprecedented growth, if you were to throw darts blindly at earlier price history from 2011 to 2016 and define those areas as buy points, you would likely do quite well, go ahead and try!
The point I’m trying to illustrate is that a lot of indicators will do brilliantly under conditions of exponential growth, but the real test comes in more challenging situations such as those we are witnessing today.
That said being said, this combination of two short term and two longer torm moving averages has yielded good results historically, even in recent times the buy areas have been reasonable. After all, 36% and 47% increase in price is quite significant.
Keep in mind that the price has increased significantly over time, it would require a lot more capital to move the price now than before. This means that I doubt we will see a max gains number of the past, and 36% and 47% are are still impressive movements for a digital asset priced around or close to 5 digits.
I think the hash ribbons indicator has proven it can be a useful indicator, and there is no data at this time which suggests that it should be written off entirely.
Keep in mind, the price has increased significantly, it would require a lot more capital to move the price now than before. This means that I doubt we will see a max gains number of the past, and 36% and 47% is are still impressive movements for a digital asset priced around or close to 5 digits.
The hash ribbons indicator could work well as a spot-buying indicator, or very low (max 1X) leveraged trades, preferably when it is confluent with some of your other strategies.
When you directly buy bitcoin that you will own, and not just contracts on margin exchanges.
Historically, the price increase happens over time and not immediately, thus holding a high leverage position would be unnecessarily risky and funding payment would be unfortunate for a prolonged time. With spot buys you would avoid any risk related to margin and funding, but it is considered to be more capital intensive.
I think it’s great to get some attempts at fundamental indicators on bitcoin, it is something that is severely lacking when it comes to digital assets in general and hopefully, we will see more attempts in the future. Whether you want to use the indicator or not, I believe it’s worth keeping on eye out when the buy signal is indicated until the hash ribbon has proven to not to work, if that were ever to happen.
I’m excited to see how accurate it will be able to point out bitcoin bottoms in the future and if my theory of continuous diminished gains after mining capitulation is correct.
Thanks to Charles Edwards at Capriole Investments for the introduction to the hash ribbons indicator and the open-source code.