How To Use AVWAPs With Crypto

Louis Sykes
August 3, 2022

From the Desk of Louis Sykes @haumicharts

In the arsenal of every trader and technical analyst lies a countless number of indicators, metrics, and tools.

Everyone in the business is aware of the classic indicators: moving averages, Fibonacci extensions, momentum oscillators... the list goes on.

Perhaps one of the most valuable tools is the AVWAP. This is merely a representation of the average price by volume anchored to a specific time.

The AVWAP works because it takes advantage of human psychology. It's universally accepted within the scientific community that humans are driven by a slew of biases. Ask any trader, and they'll attest.

An incredibly common heuristic that drives much of the financial industry is the age-old anchoring bias. Many traders irrationally make decisions solely based on the price they paid for a stock.

In this sense, the market is driven by these participants responding to supply/demand dynamics within the context of their personal anchoring.

The implications of such indicators are that they allow us to gauge an aggregate cost basis of specific securities, ETFs, and financial instruments anchored to a specified date.

As a result, we can understand where the breakeven points lie for traders and investors as a collective.

This insight allows us to use AVWAPs in support/resistance trading, as well as to exploit weaknesses when investors are underwater.

In essence, a VWAP is the average price of a stock weighted by the total trading volume. The VWAP is used to calculate the average price of a stock over a period of time.

It's calculated by multiplying typical price by volume and then dividing by total volume.

An AVWAP, meanwhile, anchors the beginning of the VWAP calculation to a specific date.

For greater detail on the AVWAP, this is a great resource.

But, when we apply this to the world of digital assets and cryptocurrencies, it becomes a more complicated practice.

This is particularly driven by the decentralized nature of the asset class; while equities are traded on a single, centralized exchange, cryptocurrencies trade on a number of global exchanges.

Further complicating matters is the numerous products on offer. Much of trading occurs outside of spot exchanges and is conducted in perpetual and traditional calendar futures.

And to add even more complexity is realizing that much of the value transacting between market participants is taking place on-chain and on decentralized financial protocols completely away from the custodians of exchanges.

In fact, the vast majority of transfers between investors are not taking place on the typical spot exchanges, like Binance, Coinbase, Gemini, and others.

There's a whole lot to unpack here, so let's break it down.

1. Different Exchanges

As crypto trades on numerous exchanges, the volume characteristics are going to differ materially between each exchange.

The below chart compares the AVWAP from the pandemic lows in a handful of popular products:

  • BTCUSD, Bitstamp
  • BTCUSD, Coinbase
  • BTCUSDT, Binance
  • BTCUSD, FTX

In all cases, the AVWAP differs significantly, ranging from 25,700 on Bitstamp to 40,800 on FTX -- a difference greater than 15,000. And this is only comparing four spot products.

Even if you aren't trading the AVWAP to the penny and use it merely as a guide, the significant difference between each product turns the indicator into noise.

"Successful" tests of long-term crypto AVWAPs are likely by coincidence rather than the indicator providing any level of meaningful edge.

2. Different Products

Further is the fact that cryptocurrencies trade as both perpetual and calendar futures as well as spot.

I've found that if you are going to use AVWAPs in crypto, it's best to limit them to short-term trading (nothing beyond three months, but the shorter the time frame the better) and to only use them on perpetual futures contracts, not spot. This is for two primary reasons:

  • First, and probably more important, is that the further away you anchor your VWAP, the greater time there is for slight discrepancies in volume within each product will cause a larger shift in the AVWAP. This causes the major differences that we noted in the above chart.
  • The overwhelming majority of short-term trading takes place on perps as opposed to spot. These products are significantly more liquid and cheaper for short-term positioning. Traders utilizing perps aren't going to hold positions for any longer than three months at maximum, but, usually, it's much shorter. This is because the cost of paying funding on perpetual contracts gets more expensive the longer you go out.

For instance, if we were to compare a handful of popular perp Ethereum products on a 30-minute time frame, they line up relatively well. This is despite the fact they're all on separate exchanges.

3. On-Chain Transactions

It goes without saying that AVWAPs only incorporate transactions within an exchange.

What this analysis ignores is the vast quantity of capital moving off exchanges and on-chain. This not only includes cold wallets but capital tied up in decentralized protocols and exchanges.

As of the writing of this post, Bitcoin has traded $27B over the last 24 hours on both spot and derivatives exchanges.

Meanwhile, transfer volume taking place on-chain ranges from $50B on a quiet day to a monumental $300B at its peak in November 2021. AVWAPs fail to incorporate the majority of volume trading between market participants.

When this is incorporated into the analysis, the efficacy of AVWAPs in crypto continues to weaken.

A potential solution to this conundrum is to utilize data on-chain that does a similar (and better) job of visualizing cost basis among crypto market participants.

A mainstream method would be to evaluate the realized price, which values each UTXO (coin) from when it was last moved. Hence, it represents the aggregate cost basis of all Bitcoin's free-float supply.

Another, more sophisticated approach would be to segregate Bitcoin holders by the maturity of the coins they hold.

Glassnode has shown that 155 days is a statistically significant threshold whereby entities that have held for more than 155 days tend to continue to hold their coins.

So we can break down the realized price for short-term holders (coins that were last moved less than 155 days ago) and that of long-term holders (coins last moved more than 155 days ago).

The short-term holder realized price has shown itself to be a great tool to supplement our traditional price analysis, whereby it acts as support in bull markets and resistance in bear markets.

Another potential solution is to analyze the profitability of coins being spent.

If the AVWAP tracks a collective cost basis of investors anchored to a specific time period, we can duplicate the results of this by seeing when coins are being sold at breakeven.

The spent output profit ratio (SOPR) tracks this very dynamic and is a great indicator we employ in trending markets. The SOPR tracks the profits and losses being realized on-chain, so it can also give us a reasonable read into when profit taking is complete.

In bull markets, holders are reluctant to sell at losses, so when the SOPR undercuts 1, signaling that losses are being realized, supply has a tendency to dry up, marking the bottom of the dip.

On the contrary, bear market rallies end when underwater holders get out at breakeven. Here's a representation of how well the SOPR works in a strong trending market.

We can also apply this over short time frames.

Here's the most recent price action overlaid with the SOPR.

Metrics like these are far more useful, practical, and overall superior to long-term AVWAPs in cryptocurrencies.

In Sum

AVWAPs are great tools for legacy traders and investors. They enable analysts to gauge the collective cost basis of investors and is a great supplement to supply/demand trading.

But, when applied to cryptocurrencies, it becomes a lot more complex and nuanced.

On a surface level, different exchanges and products will have materially different AVWAPs, making it a noisy indicator for those with long-term time horizons.

The only exception I've found where it's appropriate to use AVWAPs in crypto is for short-term traders utilizing perpetual futures.

The very nature of cryptocurrencies allows us to more accurately follow money flow in ways that are impossible in legacy markets.

So why limit yourself to AVWAPs, which in crypto terms is a relatively archaic way of breaking down supply and demand dynamics?

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Thanks for reading, and please let us know if you have any questions!

Allstarcharts Team

 

 

 

 

 

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