One popular method of fundamental analysis for cryptocurrencies is based on the idea of cryptocurrency as a form of money and using the famous quantity theory equation. Known as the Network Value to Transaction ratio, this metric tells us when bitcoin is overvalued or undervalued based on the value of daily transactions.
What is the Network Value to Transactions (NVT) Ratio?
The Network Value to Transactions (NVT) ratio was created by Coin Metrics and cryptocurrency analysts Chris Burniske and Willy Woo in February 2017 as a method of valuing bitcoin. The NVT ratio divides the total network value (as measured by market capitalisation) by the daily USD volume transmitted through the blockchain and is therefore similar to a price-earnings (PE) ratio for an equity.
The NVT ratio essentially tells us whether bitcoin is over- or under-valued. If the NVT ratio is high, then it signals that the value of the network is outpacing the value being transacted on the payment network suggesting the network is experiencing either; high growth or a bubble. If the NVT ratio goes above its normal range, then it is likely that the price of bitcoin is in a bubble and would provide a warning for investors and traders to lock their profits and reduce their exposure to bitcoin.
As a lagging indicator, the NVT ratio can tell us whether there is a crash or consolidation after the price has peaked. If the NVT ratio remains in a normal range then after a price peak, it is likely that the market is consolidating. On the other hand, if the NVT ratio increases above its normal range, then expect a strong correction.
The chart below shows the NVT ratio for bitcoin and illustrate how to use the NVT ratio. The dotted green and red lines show where the NVT ratio suggests that bitcoin is overvalued or undervalued. When the NVT ratio goes above the red line, it suggests that the network value is too high compared to the network’s daily transaction volume while the opposite is true when the NVT ratio goes below the green line. Therefore, traders can consider entering long-term positions when the NVT ratio exceeds its normal range.
Source: Woobull Charts
Network Value to Transactions Ratio Signal
Dmitri Kalichki improved on the NVT ratio further to describe price bubbles without a significant time lag.
Known as the NVT Signal, this indicator can be used to pick tops and bottoms in cryptocurrencies like bitcoin. By smoothing the transactions value with a moving average. Specifically, the NVT signal uses the 90-day moving average of the daily transaction value.
The NVT Signal is more responsive than the original NVT indicator and perhaps the first trading indicator to use on-chain data. When the NVT is below 45, this indicates oversold conditions for bitcoin. However, if the NVT Signal is above 150 the market is considered to be overbought.
Source: Woobull charts
The chart above shows how the NVT Signal peaked in line with tops in the price of bitcoin. As bitcoin’s price reached a plateau of $19,500 in December 2017, the NVT Signal also peaked above its normal range around the same time providing a signal to exit longs and/or go short.
Using the NVT Ratio in Your Trading
The NVT ratio and NVT Signal can usually be used for other cryptocurrencies. For instance, Coin Metrics maintains data on the NVT and NVT Signal for altcoins such as Ethereum's ether, litecoin and XRP.
However, the NVT indicators are only useful if the value transmitted on-chain is a good representation of the network’s usage. Even with bitcoin, the NVT ratios use on-chain daily transaction values yet there are more and more transactions happening on Bitcoin's layer 2 with Liquid’s sidechain and the Lightning Network.
Therefore, as layer 2 implementations grow and become more popular, it is important to account for this activity when analysing the NVT ratio of bitcoin.