The Bitcoin Dominance Index is the proportion of the entire cryptocurrency market's valuation that is attributed to Bitcoin. The metric is typically used to show the importance of bitcoin against other cryptocurrencies.
The Bitcoin Dominance Index, displayed below, is used as a measure of the demand for bitcoin relative to the demand for altcoins. The index is calculated as the market capitalisation of bitcoin divided by the market capitalisation of the entire cryptocurrency market. When altcoins gain market share, they typically appreciate at a faster rate than BTC. When altcoins experience bullish phases, it is known as 'alt season'.
The Index falls when altcoins are gaining a larger market share of the overall cryptocurrency market or if the bitcoin share falls and altcoin market capitalisatin remain constant. The index rises when altcoins are losing market share or their combined market capitalisation is constant and bitcoin's is rising. Therefore, a rising (or falling) dominance doesn't necessarily translate to a bull (or a bear) market for Bitcoin.
As a result, the Bitcoin Dominance Index can be thought of as a proxy for cryptocurrency investor’s risk appetite, where a low Index score is associated with risk taking (or 'alt seasons') and a high Index score is interpreted as crypto investors playing it safe and flocking to bitcoin.
Prior to 2016, the Bitcoin Dominance Index remained relatively stable around 98-95%. It wasn't until the scaling debate in Bitcoin and the altcoin bull market in 2017 that the Bitcoin Dominance Index started to decline - reaching lows near 35% as the total market capitalisation of the cryptocurrency market peaked at $0.5 trillion in January 2018.
Since 2018, the Bitcoin Dominance Index has ranged between 35% and 75%. The chart below shows that extremely low or high points in the Bitcoin Dominance Index often correlate with major turning points in the market. For example, in July 2017 the Bitcoin Dominance Index fell sharply to around 50% and recovered, corresponding with a local bottom in the price of bitcoin, which fell to from around $2,600 to $2,300. After Bitcoin Dominance reached a new low, the price recovered and eventually went on to hit $4,900 in September 2017.
Another example is given by the spike in the Bitcoin Dominance Index in December 2017 which occured just before BTC-USD topped out near $20,000. The index reached highs near 70% and turned down sharply in the following days, confirming a top in the price. Similar dynamics can be seen at the end of the bull run in summer 2019.
One limitation of the Bitcoin Dominance Index is that not all coins are created and distributed in the same way. Take XRP for example, where all the coins were pre-mined but only a fraction of these coins are circulating (a large portion of XRP are under the control of Ripple Inc.) providing a misleading market capitalisation figure.
Imagine someone creates a new coin and sells 20 units for $10 each. If 1 billion coins are created in total, it follows that the market capitalisation is then $10 billion and the Bitcoin Dominance Index will fall slightly. However, in reality the effect of this new coin on the cryptocurrency market is much lower than the dent made in the Bitcoin Dominance Index.
Another limitation of the Index is that trading volume or liquidity are not accounted for. For the example above where someone creates a new coin with a supply of 1 billion, if the market capitalisation was adjusted to account for liquidity, the index would give a clearer picture of the relative strengths of different cryptocurrencies. When adjusting for liquidity, bitcoin’s dominance is suggested to be much higher (around 90%).
Therefore, traders shouldn't rely on the Bitcoin Dominance Index too much. As the index is just a proxy for the risk appetite of crypto traders and investors, you should use the information given by the Index along with other analyses and tools.