Key aspects
The Bitcoin Rainbow Chart is a charting tool that can indicate whether Bitcoin (BTC) is undervalued, fairly valued, or overvalued based on its historical prices.
It consists of a series of colored bands that represent various price ranges. The position of the price within the colored bands can provide information about market sentiment and possible long-term movements.
The BTC rainbow chart was created as a meme in 2014 by adding colors to a logarithmic scale chart. The formula changed in 2019, giving rise to the Bitcoin V2 rainbow chart.
The accuracy of the Bitcoin rainbow chart remains a matter of debate 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 bitcoins (BTC). The rainbow chart uses a series of colored bands that can indicate different phases of market sentiment, suggesting whether bitcoin is undervalued, fairly valued, or overvalued.
How was the Bitcoin rainbow chart created?
The first Bitcoin rainbow chart was created in 2014 by a Reddit user named “azop,” who designed it as a fun way to represent bitcoin’s price history. At the time, the BTC rainbow chart had no arc. It was simply made up of linear colored bands on a logarithmic scale chart.
In 2019, Bitcoin user Rohmeo changed the formula to create the Bitcoin V2 rainbow chart, which has an arc and uses a more scientific way of modeling prices. The new formula was inspired by a logarithmic regression chart created by BitcoinTalk user “trolololo” in 2014.
How to use the Bitcoin Rainbow Chart
Both the V1 and V2 versions of the BTC Rainbow Chart are available on Rohmeo’s website, BlockchainCenter. While there is no guarantee that the Rainbow Chart model will be successful in the long term, it is worth learning how to use it.
1. Identify the current price band.
Start by identifying the price band that the BTC price is in. You can do this by zooming in on the most recent price action and hovering over the price line.
2. Interpret the color of the band.
Once you have identified the current price band, you can use the suggested color scheme to interpret what it means.
According to the model, the lower colors suggest possible oversold conditions, while the upper colors suggest an overbought market. From bottom to top:
Dark Blue ("basically a fire sale"): Extremely undervalued.
Cyan ("BUY"): Very undervalued.
Green ("Accumulate"): undervalued.
Light Green ("Still cheap"): somewhat underrated.
Yellow ("HODL"): quite valued.
Orange ("Is this a bubble?"): May be overrated.
Light red ("FOMO intensifies"): Probably overvalued.
Red ("SELL"): very overrated.
Dark Red ("Maximum Bubble Territory"): Extremely overrated.
3. Take into account the historical context.
Consider looking at historical price action within different colored bands. Notice the patterns and trends that emerge when the Bitcoin price has previously been in a similar band. For example, when BTC entered the “dark blue” band in the past, what followed? Does the price typically rise shortly afterward, or does price action occur sideways?
4. Combine with other indicators.
While the Bitcoin rainbow chart can be an interesting tool for understanding market sentiment, it should be used in conjunction with other strategies and indicators to mitigate risks. Here are some additional tools you can consider:
Trading Volume: Examine bitcoin trading volume to understand market activity. For example, high trading volume often indicates strong market interest.
Technical Analysis Indicators: Consider other technical analysis tools, such as moving averages, relative strength index (RSI), and moving average convergence/divergence (MACD), to identify trends and potential reversal points.
Macroeconomics: Consider the current macroeconomic scenario before taking financial risks. How high or low are interest rates? What about inflation and global liquidity? These questions can help you understand the bigger picture and assess whether investors are more risk-averse or not.
Does the Bitcoin Rainbow Chart Work?
The accuracy of the Bitcoin rainbow chart is a topic of debate among investors and analysts. Below are several points to consider when evaluating its accuracy:
Historical basis
The Bitcoin Rainbow Chart is based on historical data and uses previous price movements to create a visual representation of market sentiment. This can provide valuable context and insight into how the price of bitcoin has performed. However, the reliance on historical data means that the chart may not fully account for new developments in the cryptocurrency market.
Logarithmic regression
The rainbow chart uses logarithmic regression to smooth out Bitcoin's volatility and create a more stable trend line. This helps illustrate long-term trends and possible price ranges, but it is not foolproof. Assumptions made when creating the regression line can affect its predictive power.
The subjectivity of color bands
The colored bands on the Bitcoin rainbow chart are determined subjectively. The definitions of “undervalued,” “fairly valued,” or “overvalued” are not fixed and can vary depending on the size of each band or who is interpreting the chart.
It should be noted that the purple band on the BTC V1 rainbow chart was added at a later stage because the previous model failed when the BTC price fell below the lower band.
Advantages of Bitcoin Rainbow Chart
The Bitcoin rainbow chart offers several advantages for cryptocurrency traders looking to optimize their trading strategies:
Provides a simple visual representation of historical price movements and market sentiment.
It can help investors understand the long-term price action of bitcoin.
Colored bands can provide some guidance on potential buy, hold, and sell opportunities.
Limitations of the Bitcoin Rainbow Chart
While the Bitcoin rainbow chart is a valuable tool for visualizing long-term market trends, it has several limitations that traders should be aware of:
It is largely based on historical data and does not take into account recent events or developments in the cryptocurrency market.
The number of bands, colors and other parameters are subjective, which can lead to different results and conclusions.
Are there other cryptocurrency rainbow charts?
While the Bitcoin rainbow chart remains the most well-known, the concept has also been adapted for Ethereum. Like the Bitcoin rainbow chart, the Ethereum rainbow chart applies colored bands to the price history of Ethereum.
Conclusions
The Bitcoin Rainbow Chart is a tool that helps visualize Bitcoin's historical price action and market sentiment. Investors can use it to identify potential buy, hold, or sell opportunities. However, it is important to combine it with other indicators to mitigate risks and increase your chances of success.
Further reading
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