What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

This article explores the impact of open interest volume, Bitcoin’s exchange balance, and their ratio Estimated Leverage Ratio on coin prices.

Written by Peter Guo

Original Title: “Crypto Market from Estimated Leverage Ratio (ELR)

This article is based on the author’s independent research and analysis, and is for reference only and does not constitute any investment advice. PayPal Financial assumes no responsibility for the reader’s use of this article and any consequences arising therefrom.
Summary.
On April 18, 2021 Bitcoin suddenly plunged by up to 15%, driving cryptocurrencies down sharply across the board and causing nearly 1 million accounts to explode by over $10 billion.

As we entered mid-May, Bitcoin began an even more dramatic downward spiral, with the market triggering a continuous stampede downward due to excessive leverage.

This once again triggered the market to think about excessive leverage, and this article does a preliminary discussion on the relationship between Estimated Leverage Ratio (ELR) and coin prices, trying to draw basic methods and conclusions that can help predict market trends.

I. Basic Concept
The Estimated Leverage Ratio is the ratio of open interest to the balance of the Bitcoin exchange, and we will discuss the meaning of these three indicators in turn.

  1. Open Interest Volume (OI)
    Open Interest (OI) is the cumulative amount of open positions in the market for all contracts, also known as short interest and open interest, and is an important indicator of contract market activity and liquidity.

Generally speaking, when the price of a cryptocurrency continues a previous trend, if the open interest volume increases, it indicates that traders are optimistic about the continuation of the trend, while the opposite indicates that traders are taking profits and are cautiously watching the future trend.

In the cryptocurrency market, open interest volume (OI) and volume (VOL) are the primary tools for determining price continuation or inflection points.

As shown in the chart below, when Bitcoin maintains a bullish upward trend, OI, VOL and coin price are kept in sync with each other in terms of volume and price, while extreme high volumes and high positions are often indicative of an overbought phase of the market, making it an important basis for predicting phase highs.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 1 Source: bybt

2, Bitcoin Balance on Exchanges (Balance on Exchanges)
Bitcoin’s Balance on Exchanges is the amount of bitcoin in an exchange wallet and is an important observational tool to measure the selling pressure in the market.

Generally speaking, if the exchange balance continues to increase, it indicates that the demand for liquidity from holders is expanding and the price of bitcoin is likely to fall, while the opposite indicates that holders are more willing to store bitcoin for a long time and the market liquidity supply is decreasing and the price of bitcoin is likely to rise.

Over the long term, bitcoin balances on exchanges have been a net inflow, reflecting the historical progression of coin holders from niche trading to an expanding trading community. But that has changed over the past year or so.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 2 Source: santiment, Babel Finance

As shown in the chart above, the number of bitcoins on exchanges has shaken down since the 312 crash last year. Even as Bitcoin has seen an unprecedented bull market, long-term holders seem unmoved, with only a brief sell-off from November 2020 to January 2021 when there was some net inflow. Against the backdrop of both an internal supply/demand imbalance and an external supply glut of U.S. dollars, market demand for bitcoin has remained strong, driving the price higher.

  1. Estimated Leverage Ratio (ELR)
    While Open Interest and Balance on Exchanges are somewhat indicative of long and short market sentiment, we need a more sensitive tool to measure traders’ appetite for holding and opening new positions, namely the Estimated Leverage Ratio (ELR). Leverage Ratio (ELR).

The Estimated Leverage Ratio (ELR), as the name implies, estimates the average trader leverage, which we express as a ratio of open positions to the number of bitcoins currently on the exchange.

Cryptocurrencies are currently in a highly leveraged structured market driven by derivatives, where investors tend to use leverage in the contract market to improve capital efficiency, which can amplify the profit and loss of a position in a short period of time.

On the Cryptocurrency Exchange, for example, bitcoin futures contracts offer 1-125x leverage and ethereum contracts offer 1-75x leverage. If a user is long bitcoin at 100x leverage, the account margin can blow up or double as soon as the price of the currency fluctuates by 1%. Once the price fluctuates significantly, the market is prone to cascading liquidation, so the high leverage somewhat contributes to the high volatility of the Bitcoin market.

The Estimated Leverage Ratio (ELR) is just the thing to assist us in understanding traders’ leverage usage and better grasp the overall market sentiment.

II. Exploring the relationship between ELR and coin price

  1. ELR predicts market continuity
    ELR can measure traders’ confidence in their positions. In general, in a bull market, if ELR increases over time, it indicates that traders are using relatively more leverage, increasing their risk exposure and having more confidence in their bullish positions; conversely, as the price of the currency continues to rise, ELR decreases. The psychology behind this divergence is that traders are “scared of the highs” and are starting to reduce leverage to cope with the uncertain future volatility.
What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?
What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 3 and 4 Source: CryptoQuant

As the chart above shows, the ELR values of BTC and ETH fluctuated in the same direction as the coin price from January 2021 to April 22, 2021, and even at certain times the ELR was slightly ahead of the coin price in terms of tops and bottoms. But ETH’s ELR value began to move downward after entering April, creating a divergence from the coin price’s record high, and the aftermath saw a big drop on April 18.

  1. ELR predicts the market inflection point
    ELR is essentially an oscillator. When leverage is too high or too low, the market will produce an overbought or oversold situation, and once this overly speculative atmosphere ends, the price trend will often usher in a turnaround.

The chart below shows the ELR versus coin price for the last year, with the ELR fluctuating widely between 0.1 and 0.2. Although there is no data reference for a longer period yet, we can still roughly observe the impact on the coin price when the ELR is too small or too large.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Chart 5 Source: CryptoQuant

When the ELR is greater than 0.2, the market may be at a phase top of a bull market, or the end of a bear market rally. Investors should combine other methods to see if the coin price is overbought, and prepare to protect profits on long positions, or prepare to take short positions.

When ELR falls to around 0.1, the market may be at a bearish phase bottom or the end of a bullish retracement. Investors should combine other methods to observe whether the coin price is oversold, and make good profit protection for short positions, or prepare to take long positions.

Of course whether such an assumption will work in the future remains to be verified over time.

  1. ELR analysis of market stage drivers
    The above article explored the use of estimated leverage to guide the continuation or reversal of the coin price, but it is clear that the above chart appears to be the case of two phases of ELR and coin price synchronization and reversal, how should this be explained? We present here the hypothesis of market phase drivers in the context of the market over the last year.

As seen in the chart above, since May to July 2020, the coin price rose by 30% during the period, while the ELR rose from 0.1 to 0.2, mainly due to the continued decline in bitcoin’s exchange balance, the market demand began to gradually outweigh the supply, and the coin price appeared to be snapped up.

The ELR has been oscillating slightly since July to December 2020, a period that coincided with a continued net outflow of bitcoin volume from exchanges and a continued buying of BTC by institutions such as GrayScale. In other words, the ELR did not get larger or even decreased during the period when BTC rose from $10,000 to $40,000, which most likely indicates that this bull market was driven by new money buying spot from institutional entry, and the derivatives leverage drive has not yet dominated.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 6 Source: bybt

From January 2021 to date, we have finally seen the ELR fluctuate up and down in tandem with the BTC price, the volume of bitcoin on exchanges remains net outflows, the number of open contracts continues to reach record highs, and the ELR rises from 0.1 to near 0.19, with high leverage bringing high volatility to the coin price.

This period also overlaps with the second half of last year when institutions phased out opening new positions. In other words, the ELR rose sharply during the period when BTC went from a pullback to $30,000 to $60,000, which probably indicates that the bull market was driven by high leverage in contract derivatives.

We also compared the ELR values of several exchanges, such as Binance, OKEx, Huobi, etc., that mainly cater to the Chinese market with international exchanges (Bybit, BitMEX) during this period, and found that there was a simultaneous net outflow of bitcoin from the exchanges during this period, but the latter ELR values were much higher than the former ELR values, which validates the current market view that foreign countries dominate the bitcoin market.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?
What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 7 and 8 Source: CryptoQuant

4、ELR combined with other indicators
A similar market pointing to ELR is the funding rate of perpetual contracts (Funding Rate).

When the price of a perpetual contract deviates from the spot index price, the system will adjust the long and short forces through the “funding rate mechanism” to keep it in sync with the spot price.

Similarly, when the funding rate is positive, it means that the market is strong and willing to push up the price, and will pay a certain fee to the short side, and vice versa.

So theoretically, if the funding rate is positive and continues to rise, it means that the market is exuberantly long and the ELR should also increase.

What is the relationship between the Estimated Leverage Ratio (ELR) and the price of the currency?

Figure 9 Source: CryptoQuant, BitMEX, Babel Finance

As shown in the chart above, the ELR and Funding Rate are shown as stacked dashes, with the two movements showing a somewhat positive synchronized relationship. For most of the time period, although the brief detailed fluctuations can vary, overall they convey the same message of long-short market sentiment: when the coin price rises healthily, ELR and Funding Rate are likely to move up in tandem, and vice versa.

Furthermore, since they are both relative indicators, if they are both at very high or low, it indicates that the market is in a severe overbought/oversold posture and is likely to usher in a significant trend reversal.

There is published research indicating that since October 2018, when the Funding Rate is above 0.10% in absolute terms, it indicates that the market may be entering an excessive speculative phase. If the Funding Rate is positive at this point, it is a better time to sell, and vice versa.

For investors, when the Funding Rate is too high, the estimated leverage is also at a relatively high position, when it is appropriate to short to hedge and earn funding fees.

In Figure 9, we observe that on November 23, 2020, February 18, 2021, March 14, 2021, and April 13, 2021, both indicators are at a higher position and the market has triggered a downward adjustment in the aftermath.

Summary
This article has explored the impact of open contract volume, Bitcoin’s exchange balance, and their ratio predicted leverage on the coin price.

Overall, the ELR can answer two important questions: (i) the stage the market trend is at and the drivers; and (ii) predicting market continuation or excessive sentiment. As the ELR gradually becomes larger, investors’ demand for leverage increases and may continue the current trend, but a rise to a certain level may signal that greater price volatility is imminent, and vice versa.

Of course, since ELR is not a relatively accurate indicator and lacks sufficient historical data, there are some limitations when using it to track market trading sentiment, and investors should use it in conjunction with other tools.

References.

1, https://cryptopotato.com/crypto-trading-academy-what-is-open-interest-in-bitcoin-futures-and-how-traders-use-it/

2, https://www.longhash.com/cn/news/3289

3、https://www.coingogo.com/news/53646

4、https://studio.glassnode.com/metrics?a=BTC&m=distribution.BalanceExchanges&resolution=24h

5、https://dataguide.cryptoquant.com/market-indicators/estimated-leverage-ratio

6、https://www.wk588.com/33289-1-7.html

7、https://support.hbfile.net/hc/zh-cn/articles/900001326466

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-is-the-relationship-between-the-estimated-leverage-ratio-elr-and-the-price-of-the-currency/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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