Key Points
The Bitcoin Rainbow Chart is a Bitcoin valuation chart tool that uses historical prices to show whether Bitcoin (BTC) is undervalued, reasonably valued, or overvalued.
The chart consists of a series of colored bands representing different prices. The position of the price within the bands can reflect the market sentiment and potential long-term trend of Bitcoin.
The BTC rainbow chart appeared as a meme in 2014 and was created by adding colors to a logarithmic scale chart. In 2019, the Bitcoin Rainbow Chart V2 version came into being, with some changes to the original formula.
The accuracy of the Bitcoin Rainbow Chart has been controversial due to its heavy reliance on historical data and subjective parameters.
What is the BTC Rainbow Chart?
The Bitcoin Rainbow Chart is a technical analysis tool used to track the performance of Bitcoin (BTC). The Rainbow Chart uses a series of color bands to represent different stages of market sentiment, reflecting whether Bitcoin is undervalued, fairly valued, or overvalued.
How did the Bitcoin rainbow chart come about?
The first Bitcoin rainbow chart was created in 2014 by Reddit user "azop", who wanted the chart to show Bitcoin's price history in an interesting way. At that time, the Bitcoin rainbow chart did not have curved arcs, but just a few straight ribbons on a logarithmic scale.
In 2019, Bitcoin user Rohmeo modified the formula to create the curved Bitcoin Rainbow V2, which models prices in a more scientific way. The new formula was inspired by a logarithmic regression chart created by BitcoinTalk user "trolololo" in 2014.
How to use Bitcoin Rainbow Chart
Both V1 and V2 versions of the BTC Rainbow Chart can be found on Rohmeo's BlockchainCenter website. The Rainbow Chart model cannot guarantee accurate long-term trend predictions, but its use is still worth learning.
1. Determine the current price band.
First determine the price band that the current BTC price is in. Zoom in on the latest price action and do this by hovering your cursor over the price line.
2. Annotate the price band color.
Once you have determined your current price band, you can then interpret the meaning of the various colors based on the suggested color scheme.
The colors at the bottom of the model indicate potential oversold conditions, while the colors at the top indicate that the market is overbought. From bottom to top, the colors are:
Dark Blue (“Basically a fire sale”): Severely undervalued.
Cyan (“Buy Now!”): Clearly undervalued.
Green (“Overweight”): Undervalued.
Light Green (“Still Cheap”): Slightly undervalued.
Yellow (“Hold for the Long Term!”): Fairly valued.
Orange (“Is this a bubble?”): Seems a bit overrated.
Light red (“heightened FOMO”): Likely overvalued.
Red (“Sell now!”): Severely overvalued.
Dark red (“maximum bubble area”): extremely overvalued.
3. Refer to the historical context.
It is recommended to look at historical price behavior within the different colored bands. Keep an eye out for patterns and trends that have occurred when Bitcoin price has been in similar ranges before. For example, when BTC previously entered the "dark blue" band, what happened afterwards? Did the price rise quickly afterwards, or did it experience sideways price behavior?
4. Use in combination with other indicators.
The Bitcoin Rainbow Chart is an interesting tool for understanding market sentiment, but should be used in conjunction with other strategies and indicators to reduce risk. Here are some tools worth considering:
Volume: Studying Bitcoin's trading volume can provide insights into market activity. For example, high volumes generally indicate strong market interest.
Technical Analysis Indicators: Use a combination of technical analysis tools such as the Moving Average, Relative Strength Index (RSI) and Exponential Moving Average (MACD) to identify trends and potential reversal points.
Macroeconomics: Before taking on financial risk, consider the current macroeconomic situation. Are interest rates high or low? What is the inflation and global liquidity situation like? These questions can help you see the big picture and assess whether investors' risk appetite is risk-seeking or risk-averse.
Does the Bitcoin Rainbow Chart Work?
The accuracy of the Bitcoin rainbow chart is a hotly debated topic among investors and analysts. There are a few things to consider when evaluating the chart’s accuracy:
Historical basis
The Bitcoin Rainbow Chart is based on historical data, using past price movements to visually reflect market sentiment. This can provide valuable context and insights into Bitcoin price movements. However, reliance on historical data means that the chart may not fully reflect new developments in the cryptocurrency market.
Logarithmic Regression
The Rainbow chart uses logarithmic regression to smooth out Bitcoin's volatility, creating a more stable trend line. This helps to illustrate long-term trends and potential price ranges, but it is not foolproof. The assumptions made when creating the regression line will affect its predictive power.
The Subjectivity of Color Ribbons
The colors of the ribbons in the Bitcoin rainbow are determined subjectively. The definitions of "undervalued," "fairly valued," or "overvalued" are not fixed and may vary depending on the width of the ribbons or the user's interpretation of the chart.
It is worth noting that the purple band of the BTC Rainbow Chart V1 version was added later because the previous model failed when the BTC price fell below the lowest band.
Advantages of Bitcoin Rainbow Chart
The Bitcoin Rainbow Chart offers several advantages to cryptocurrency traders seeking to optimize their trading strategies:
The chart presents historical price trends and market sentiment in a simple and intuitive way.
Helps investors understand the long-term price behavior of Bitcoin.
The ribbons can provide some guidance on potential buy, hold, and sell opportunities.
Limitations of Bitcoin’s Rainbow Chart
The Bitcoin Rainbow Chart is a useful tool for visualizing long-term market trends, but it does have limitations that traders should be aware of:
The chart relies heavily on historical data and does not take into account recent events or developments in the cryptocurrency market.
The number of bands, their colors, and other parameters are subjective and may cause results and conclusions to vary.
Do other cryptocurrencies have rainbow charts?
The Bitcoin rainbow chart is the most famous, but the concept has been borrowed by Ethereum. Similar to the Bitcoin rainbow chart, the Ethereum rainbow chart uses color bands to represent the historical price of Ethereum.
Conclusion
The Bitcoin Rainbow Chart tool effectively visualizes Bitcoin's historical price behavior and market sentiment. Investors can use the Bitcoin Rainbow Chart to identify potential buy, hold or sell opportunities. But be sure to use it in conjunction with other indicators to reduce risk and increase the chance of success.
Further reading
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