Where do the pricing of cryptocurrencies come from?

• Learn about the process of pricing formation.

• Recognize the importance of exchanges

• What kind of price data does an exchange deliver？

• Order books and depth charts interpretation

We distinguished between risk and possibility in terms of short-term market volatility and long-term asset performance in the first piece of this series on how to trade cryptocurrencies.

In general, Investing focuses on the long term, while Trading refers to the implementation of plans within a short time period.

Because the focus is primarily on short-term price volatility, which is driven by different variables than those that play out over months and years, trading necessitates a special form of analysis.

This is known as technical analysis, and to grasp it, you must first comprehend the fundamentals, such as what a price is and where it comes from.

What does the price of bitcoin mean, and where does it come from？

Using bitcoin as an example, price is a measurement of the perceived worth of bitcoin in comparison to an existing currency (such as the Euro) that is determined by buyer-seller transactions.

A Trading Pair is the price relationship between two assets, such as bitcoin and the Euro, and it is represented by a three-letter ticker symbol: BTC/EUR

Although perceived value is entirely subjective, the most widely held belief is that bitcoin's value stems from its ability to serve as a new sort of online money, serving as both a store of value and a medium of trade.

Buyers believe bitcoin's price (measured in Euros) will climb, that it is undervalued in comparison to its future potential as a new currency, but opinions will differ on what price is appropriate to purchase at any given time.

Sellers already own bitcoin but are eager to sell them because they believe the relative Euro price will fall in the near future or that there are better relative prospects for which they want to release their wealth.

Each vendor will have a different opinion on what the best selling price is.

When the opinions of these two groups - buyers and sellers - collide, a Euro equivalent cost is determined: the greatest price a Buyer is ready to pay is matched with the lowest price a Seller is willing to sell at, and an exchange occurs.

The Spot Price is a term used to define the price that buyers and sellers are willing to accept on the spot, or right then and there.

Other price mechanisms, known as derivatives, emerge as markets for an asset mature, allowing speculation on the price at some point in the future.

Futures are an important part of price discovery, and the launch of bitcoin futures in December 2017 was a watershed moment for other bitcoin-related financial products like an Exchange Traded Fund (ETF), which allows investors to invest in a fund that simply tracks bitcoin's price without actually owning any.

Exchanges & Price Discovery

The process of determining a reasonable price for bitcoin is known as price discovery. In principle, every market member will use all available bitcoin information - technical and fundamental - as well as the behavior of other market players to determine the genuine price.

We'll go through the influences on price discovery later in the section, but for now, let's just introduce the concept of market participants discovering price and exchanges facilitating trading.

Exchanges connect buyers and sellers, who are looking to express their opinions on price through trades, on a continuous basis, 24 hours a day, 7 days a week, generating bitcoin's price - and this is where pricing originates from; an agreement on perceived value at a certain time.

There is no one source of pricing truth for bitcoin outside of exchanges; each exchange platform works independently, matching the supply (sellers) and demand (buyers) of its own consumers.

Price aggregators, such as Coinmarketcap, collect prices from the top exchanges and calculate a weighted average based on transaction volume.

to arrive at a wide price value

The image below shows that there is a pricing gap among the top ten exchanges contributing to bitcoin trading activity. Where the Trading Pair is different, the difference is bigger.

The aggregated exchange data from Coinmarketcap can be deemed reliable enough to constitute a price benchmark for bitcoin, although price discovery can be affected because the ability to buy bitcoin varies around the world.

Bitcoin Price Discovery Obstacles

When market circumstances are the same, price differences between exchanges are minimal, indicating an efficient market. If this were not the case, customers would just buy at the lowest possible price on exchange A and sell at the highest available price on exchange B (a practice known as arbitrage).

Bitcoin has a long way to go in comparison to more mature assets like gold or fiat currencies, but because billions are moved every day, its pricing is getting more efficient, meaning it rarely trades at a big premium across exchanges. Arbitrage does occur, but it is only successful at scale - by professional traders - and is irrelevant to someone learning how to trade bitcoin for the first time.

However, there is one key exception to bitcoin's price discovery: the possibility of large fluctuation across exchanges.

Where an exchange operates under alternative market conditions, such as nations with weak fiat currencies and tight controls on its exchange/movement, such as Venezuela, Argentina, Nigeria, and Turkey, the price of bitcoin will actually be much higher as demand is great.

The idea is shown in this recent Coindesk article, which shows bitcoin selling at a premium in Nigeria due to the weakening of the Naira and attempts to legislate against its use. The premium is based on the informal conversion (black market pricing) of the Naira to the Dollar, not on the price of bitcoin.

Because the demand from people in Turkey can only be met locally, the limits placed on buying and selling in those specific marketplaces hinder the natural process of price discovery. The logistics of having access to buy/sell across these markets make arbitrage challenging.

Over-the-Counter Purchases (OTC)

So, in a nutshell, we now know how bitcoin's price is determined by the interplay of buyers and sellers on exchanges.

Though, exchanges aren't the only option to purchase bitcoin.

If a person or a company wants to purchase or sell a significant number of bitcoin, they may not want to use an exchange because there are unlikely to be enough buyers or sellers at the price they want to implement at. And, because exchanges reveal trading intent (as we'll see below), placing an order on an exchange can cause price to shift.

OTC - Over the Counter - refers to transactions that take place outside of the traditional exchange market system. Trades are arranged through a broker and involve substantial quantities of money. As we deconstruct this part, we'll go over OTC in further detail.

The interaction mentioned between buyers and sellers at exchanges is aired in real time, with the exception of actual customer details, and interpreting the information is an important aspect of the art of trading.

Order Book for the Exchange

An exchange will reveal what price a buyer is willing to pay for bitcoin and how much they want to pay for it. This is known as a Bid.

The Order Book of Sellers will be displayed alongside the list of Bids, which will be arranged by price, and will detail the sell Offers, including the price and amount that Sellers are willing to exchange it for. This is referred to as a Request.

This data illustrates how buyers and sellers have a push and pull effect on price.

When a Bid and an Ask are matched, a transaction occurs that determines the price.

As a trader, you're attempting to decipher what the Order Book is saying about aggregate interest: is it skewed toward selling or buying？ Significant Bids at a certain price may indicate support levels, while significant Asks may indicate a price resistance level.

The Order Book represents Limit Orders, which are trades requested at certain prices for specific quantities. Market Orders will also be used to trade Bitcoin, when the buyer or seller is willing to accept the best available price at the time.

Chart of Exchange Depth

Bids and Asks, as well as their relative quantities, are visually depicted in a Depth Chart to help provide a simple method to grasp what the Order Book is saying.

The Depth Chart is essentially V-shaped, with prospective purchasers on one side (from the Order Book) and the highest Bid meeting the lowest Ask of all potential Sellers on the other.

The Depth Chart can help you locate resistance levels - where a falling price is likely to stabilize - and sale walls - where a rising price is likely to struggle to overcome a big number of Asks at a particular price.

The Order Book and Depth Chart, of course, are dynamic.

Because everyone's mood changes all the time, what you learn from the data is only as valuable as the sentiment's consistency.

As a result, you'll need to keep an eye on the information that the charts are reacting to when analyzing and digesting charts. We'll talk about it later.

Trades that have been completed

A trade is conducted after the purchaser and seller have met at a point that satisfies both - either through Market or Limit Orders - and the price at that moment in time is defined.

Historic trades are also available as part of a Trading Display and can provide useful retrospective data, although a Price Chart is the easiest basic representation.

A price chart provides a simple visual indication to price history as well as the ability to deduce patterns that may subsequently be used as the secret sauce in your attempt to anticipate future price.

The next step in learning how to trade cryptocurrencies is to learn how to read a price chart.