One of the most important activities when it comes to cryptocurrencies is trading. Every day, hundreds of millions of dollars in cryptocurrencies are traded by users of the blockchain network on exchanges, in order to profit, exchange, sell or buy cryptocurrencies. Knowing the ideal time to trade is what defines a good trader. And for this, many use several tools and indicators capable of showing trends, price channels, graphic figures or even growth curves. This is exactly the case with the Rainbow Chart Indicator.
The Rainbow Chart Indicator is a free tool, developed by the users themselves in order to help investors better understand the price of a cryptocurrency in relation to its already displayed growth.
Depending on how the chart is interpreted, you can use the tool to predict future prices, visualize patterns, or identify market sentiment relative to the current price of a given cryptocurrency, considering the expected growth for it in a given period.
The graphic is separated into bands and has a funnier background coloring them in the colors of the rainbow for each section. The most famous indicator in this style is the Bitcoin Rainbow Chart, widely used and commented on in crypto communities as a starting point to decide when it may be time to buy, sell or hold.
The Bitcoin Rainbow Chart was initially developed by a user on Reddit, only to display Bitcoin’s price trend (in fact, the Rainbow Indicator was created a decade earlier as a moving average based trend indicator, but was later applied to Bitcoin by cryptocurrency enthusiasts). The graphic was initially successful with its precision and colorful design. Then another BitcoinTalk user inserted a regression model, increasing accuracy and giving the graph the curve that makes it more similar to the current model. Today, it follows a logarithmic growth curve, i.e. it has its bands based on a nonlinear logarithmic regression.
Original charts of 2014, before the logarithmic regression
A logarithmic curve is obtained through a statistical analysis of the past price, aiming to predict a possible future price. But what do all these mathematical terms mean and how do they apply to Bitcoin?
In the case of Bitcoin, we compared the variables price and time. This means that the value of BTC changes over time, however, this price does not follow a line of predefined values. If BTC increased by $2 each day, we could say that in two days, Bitcoin would be worth $4 more than it is today. But we know that’s not how Bitcoin works, because it varies.
When we try to predict the next value of Bitcoin, we analyze the previous values of the variables (past prices in past periods), identify a pattern, and see how much previous prices vary from this pattern. In other words, the correlation between the price and time variables changes, since the value of the price growth coefficient is not the same at different times of time. In addition, statistically speaking, when we apply the same forecast formula in past periods, the lower the variation of the predicted price in relation to the real price, the more correct is this forecast. We just need to ask ourselves, “What is the probability that BTC will reach price X at time Y?”
This variation, in many mathematical models, is commonly known as R2. R2 is the percentage of the variation of the response variable that is explained by a mathematical model. It is the ratio between the explained variation and the total variation. The closer to 1, the more values are explained by the mathematical model you applied, that is, the more values were correctly predicted through the pattern you identified. Within this context, it is possible that some patterns fit better than others and show a smaller variation, or an R2 closer to 1.
This correction of the pattern is done by applying a nonlinear regression. The regression analysis is the quantification of the relationship of the behavior of a response variable in function of other variables concomitant to it. The name comes from the process created by Francis Galton when analyzing a scatter diagram with the average height of parents compared to the average height of their children, using the average height of children as a response variable and the average of parents as a predictor variable. Using line adjustment techniques, Galton finds that the line of the children’s averages regressed, that is, it had a smaller slope and was closer to the central mean.
Thus, this new line, after going through the regression process, adapted better to the data and conferred greater reliability to the dispersion of the data. In the case of Bitcoin, a nonlinear logarithmic regression presents a better R2 with Bitcoin values on the daily chart since its release in 2009.
Unlike a common chart, where the logarithmic regression is represented by a curve, in the Rainbow Chart it is represented by price variation ranges in a given period of time. These ranges show what would be the interpretations of certain values for BTC in a period, when compared to the logarithmic growth of the currency since its launch. Therefore, it is important to know how to interpret the graph and what information it can provide us.
As previously stated, the graph is divided into bands in the colors in the rainbow that represent users’ moments and sensations towards a cryptocurrency. In total, there are nine colors, but let’s summarize in five topics:
The lowest price bands are navy-blue (Basically a Fire Sale) and blue (BUY!) bands and represent cheaper currency prices, where it is more interesting for the investor to buy Bitcoin or another currency. From January 2015 until April 2017, Bitcoin went through a great period of stagnation in the blue bands. Interestingly, the price is usually in this range close to the currency’s halving dates. This is usually because investors await the shift in BTC’s shortage and its impact on price. The lower the availability of an asset, the more valuable it is. Therefore, the blue bands show purchase opportunities and moments of price accumulation.
But be careful! According to most sites that show a Rainbow Chart Indicator, the lowest blue band (although delimited in the figure) has a minimum value of 0. That is, prices below the band are still considered ‘a fire sale’. You have to be careful to identify whether what you are actually observing is an excellent opportunity for a downtrend or just a free fall in the value of your asset.
Continuing our climb in the rainbow, we see the green (Accumulate) and light green (Still Cheap) bands. Thanks to a slight price appreciation compared to the blue bands, the green bands have a price accumulation with a higher market activity. Investors typically cheer up and intensify trades by generating slight uptrends and a more intense price fluctuation in these bands. The purchase opportunity still exists and it is quite possible that things have begun to change with respect to the price of the asset you are analyzing.
We got to the middle of the chart with the yellow band. With a warning from HOLD! in capital letter, the ideal in this price range is to keep your assets and wait for a better position. All purchasing opportunities have now passed, as the price in this band is on average on the growth curve of the chart. Not cheap enough to buy and increase your investments, nor expensive enough to sell and make a profit.
The yellow band reflects the optimal price range for the period. In this way, it can be interpreted as the price forecast. Obviously, there are other variables involved, but the relationship of the current price with this band can give us a lot of information. For example, it is very common for the price to find some difficulty in overtaking this range, as the price tends to test this zone a lot and back off (in an attempt to find liquidity) before overtaking it.
More inexperienced traders who do not use the Rainbow Chart Indicator may think this is the best time to go out and make a profit, or even enter the trade. The ideal is to expect a more concrete response from the market and not be a weak hands type.
The orange (Is this a bubble?) and dark orange (FOMO intensifies) bands are located near the top of the rainbow. They are also considered regions of uncertainty in the market. The important thing in good trading is that you always buy at the low and sell at the high. If you managed to buy in the blue bands, it means that your capital has appreciated considerably.
More conservative traders would have their take-profit zones in these bands after seeing all this appreciation and fearing that this price is just a bubble ready to burst. More aggressive traders can see this area as the first step towards higher prices and the gateway to the moon.
Generally speaking, an increase in traders suffering from FOMO (Fear of Miss Out) syndrome is common in these bands and a division between safer investors and those who believe in high prices becomes clearer.
We have reached the other end of the chart with the red bands (Sell. Seriously, SELL!) and intense red (Maximum Bubble Territory). In this region, the graph itself shows a sense of urgency about the position of the BTC. These areas are very little reached by the price and represent the best possible price for Bitcoin, compared to its growth curve.
This ends up generating a stir in the market, with the increase in sales interest. This massive increase in investors rushing to sell their assets at the best price does not help hold the price for long in this region. So when that happens, it usually doesn’t last very long. You must be alert to have the best return rate.
Just like our lower band, the intense red band does not have a top. The price can go beyond the band’s drawn limit and reach… well, to the moon.
The Rainbow Chart Indicator may be more famous using the price of the BTC as the variable of its curve, but it is important to remember that it is not the only one. This type of logarithmic analysis was first used for assets on the stock exchange and was then brought to Bitcoin in 2014 in a more playful and fun way. The chart has evolved and taken the form we know today, but Bitcoin may not be the only pot of gold at the end of the rainbow.
Über Holger, or as he calls himself - Bitcoin Rainbow Chart guy - decided to develop a version of the indicator for another giant in the cryptocurrency world: the Ethereum.
According to him, “Unlike the Bitcoin Rainbow Chart which at least goes back to 2014, I literally just tweaked the formula for the chart until it fits reasonably well to the price development. I am just responding to popular requests to make an “Ethereum Rainbow Chart,” because people (and the Ethereum Community in particular) love rainbows.”
The chart goes from the end of 2015 to now and is simpler, without displaying details such as ETH 2.0 update information, for example, since the Bitcoin Rainbow Chart displays the Halvings of the coin. On the Ethereum Rainbow Chart the nine bands reappear, this time in pastel shades ranging from the lilac in the lowest band to the pink at the top of the rainbow.
More than the Bitcoin Rainbow Chart, the Ethereum Rainbow Chart has come to amuse the community with a touch of fun and cuteness, through minor adjustments to the formula already used for Bitcoin and without more complex interventions. Because of this, the chart should not be used as the sole or main reference to guide your investments.
While price forms one of the axes of the Bitcoin Rainbow Chart, the other axis is given by time. The formula used in the chart has changed over the years, since its creation in 2014 to better fit the price growth curve, based on its current values.
In a way, this means that the graph evolves over time, but it also means that the graph is more correct today than it was a while ago. Or that it is more wrong today than it will be tomorrow. Although the Bitcoin Rainbow Chart is based on a price prediction model, it cannot be taken as 100% correct as its predicted values change as a new value is added to the chart. The 2014 chart, although without the logarithmic regression, was extremely different from what we see today, as it took as reference the price increase of 2014 and the fall of 2010. But in fact, the chart is full of information, which when analyzed correctly, can point you in a general direction from where your assets can reach.
Time is an interesting factor to analyze, as Bitcoin is believed to work in a 4-year cycle around its Halvings. Halving is a process described in the Bitcoin code, which interferes with the amount of Bitcoins created per mining block. Users do the work of maintaining and securing the Bitcoin ledger and are rewarded with newly minted Bitcoin. However, about every four years, the reward for mining is cut in half (so, halved), and each halving reduces the rate at which new Bitcoin enters the supply. This creates a new cycle of supply and demand different from what we have in fiat currencies, where Bitcoin becomes scarcer over time and cannot be created according to the interests of a government or organization.
Usually, Halvings are surrounded by periods where the price remains in the blue and green areas of the rainbow, followed by a high that usually reaches or surpasses the red bands.
In the 2012 halving, the blue band was around $10 and the red one around $150. The market felt the difference in the amount of new BTC that would enter the supply every hour and as early as April 2013 there is a reflection of this with a first rise. In 2014, two major highs in January and February marked this cycle, one of $1,200 and the other of $1,000 respectively, with Bitcoin reaching the maximum price forecast.
Even with the excitement of the market and Bitcoin finally coming into emphasis in the world, after the 2016 halving the coin failed to repeat the event of the upswing duo, but it was enough to establish the coin above $5,000 for good.
Finally, the most recent halving, which took place in 2020, is one of the most interesting for all the buzz in the high history of Bitcoin, when it surpassed the $60,000 range. But the intriguing fact is that, according to BTC’s behavior over time, when comparing its growth curve, even this high history represents only a price forecast within the currency’s average. The dark orange band from April 2021 reached values of 67,500 dollars, while the intense red band exceeded the values of 130 thousand dollars.
By the time this article was written, Bitcoin presents itself halfway to its next halving, with the price in the green and blue bands since the entry of 2022. Even now, almost 1 year after the last high, with Bitcoin ranging between $20,000 and $25,000, the sensation in the market is divided between those who do not believe that the next halving will influence the price of the currency and those who believe that the market has finally understood Bitcoin’s intrinsic value as currency and urge to accumulate this asset in their wallets.
In any case, the Bitcoin Rainbow Chart continues to represent Bitcoin’s price growth curve, as a support tool, through a price forecast chart, and cannot be taken as absolute truth, but containing much more information beyond the price versus time ratio.
As previously mentioned, the Bitcoin Rainbow Chart cannot be your only guide to understanding what Bitcoin’s next step is in relation to its prices. Many trades combine tools to foster their decisions according to convergence and divergence in market behaviors.
Because it is a long-term tool, it is interesting to combine the Bitcoin Rainbow Chart with other long-term tools. One of them is the RSI (Relative Strength Index).
The RSI also functions as a forecasting tool, but this time predicting market trends. It is characterized as an indicator of momentum, in the category of oscillators and is shown as a wave graph ranging from 0 - 100. Trends with high RSI indices indicate that the market intention matches the side to which the chart is going, whether it is a bullish or bearish trend. When this occurs, we say that there is a strong tendency and that it should be perpetuated for a long time.
When the opposite occurs, that is, when there is a trend that presents low RSI, we know that this is a weak trend that may be at the end and ready to reverse.
This type of price predictor can serve as a support, along with the Bitcoin Rainbow Chart for more assertive decision making in relation to your trade.
Other examples of long-term indicators that can add up to find market mood are trading volume and long-term moving averages such as the MA-200.
Created with a fun purpose that eventually became assertive for its long eight years of creation, the Bitcoin Rainbow Chart is one of the simplest tools used by traders working with Bitcoin. The chart with a logarithmic regression evolved into a tool designed to better understand Bitcoin and its price. Although it cannot be used as an investment advice, the Bitcoin Rainbow Chart presents more information than appears to be visible, and when interpreted by an experienced trader, it may be one of the factors that differentiates a weak hand from a successful cryptocurrency investor. The fun look made the indicator one of the community favorites and it eventually expanded to other assets such as ETH. Together with other indicators, such as indicators of strength, trend and volume, it is possible to have the ideal tools for a better analysis of the graph and the economic market as a whole.