The world of decentralized finance is uniquely different from everything we have ever seen before. Just as we need robust training to trade the volatile cryptocurrency market, we should not invest in DeFi tokens and protocols without knowing how to assess them. Acquiring this knowledge helps you know if a project is undervalued, overvalued, or rightly valued. With that information, you can make informed decisions for your crypto portfolio's short and long-term growth. Amongst many others, there are seven key indicators you must not disregard when trading in the DeFi space. Let's take a look at these seven indicators.
Before choosing a protocol to invest in, it’s important to check the token supply's history and proposed analysis (date and quantity). Why? Well, supply is mostly responsible for inflation. The more the tokens are minted, the more wary investors become. If a protocol happens to have an infinite token supply, the value of your returns could be watered down.
Take, for example, Bitcoin. It has both a limited supply and a fully predictable inflation formula. However, not all protocols are this strict about their supply, which is exactly why you might want to understand the supply system before buying into a project.
Coupled with total circulating supply, market capitalization can provide much more accurate information about a project than other indicators on the list. Market capitalization refers to the total market value of the currently circulating tokens. It can be calculated by multiplying the token's price by the total number of tokens issued. When the market cap and circulating supply are inversely proportional, more information is known about the token.
A low market capitalization and high circulating supply mean the token might be headed lower. A high market capitalization and low circulating supply mean the token is headed up. Also, weighing the current market cap to the perceived market cap when all the tokens have been issued would give a fair indication of how valuable your investments are.
Token Supply on Exchanges
Despite the absence of intermediaries in carrying out transactions, most decentralized exchanges are still far behind their centralized contemporaries in terms of total liquidity available. Why? Primarily because most investors tend to trust centralized exchanges more when selling their tokens.
You should consider two token supply metrics in DeFi; the circulating supply and the total supply. If the circulating supply is low, then the token value is assumed to be increasing. If the number of new tokens issued is high, then basic demand and supply show us that the token's value will reduce.
The price-to-sales ratio is used to know undervalued or overvalued protocols. Though it may not fully depict the state of the crypto project, it gives investors a fair idea of the project's state. As the name implies, the price-to-sales compares the price to the revenue made by the company. A low ratio indicates an undervalued project, and a high ratio might mean an overvalued project.
Total Value Locked
This is one of the most revered metrics used to track DeFi projects. It refers to the number of assets staked at a time in a protocol, and it is a measure of locked tokens in a protocol. It is assumed that the more the tokens are locked, the better is the project. The major criticism of total value locked as an indicator is based on the overwhelming influence of whales for most of the DeFi usage.
All tokens can be divided into two groups based on their models; inflationary and deflationary. A project working with a deflationary model usually has a limited supply, meaning that no one can create more tokens in the future. Some even add the option to burn/destroy tokens to the model. On the other side are inflationary model projects, where more tokens are added to the market over time. Though some tokens are both inflationary and deflationary (two examples are MakerDAO and DAI), the majority of tokens fall into one of these two categories.
Mode of Allocation & Distribution
Tokens can either be offered via pre-mining or via a fair launch. Against popular belief, that a token is available via airdrops or other pre-mining methods does not make it a scam project. Publicity, compensation to team members, and public acceptance are three major reasons for pre-mining token allocation. However, make sure to check if most of the circulating supply is not held by one person (or wallet) so that you won't fall victim to rug pulls.
On the other hand, a fair launch means the community is responsible for decisions on launch, governance, and how the tokens can be earned or mined. The tokens are not accessible by anyone before the launch day. Dogecoin and Bitcoin are two popular examples of this.
Understanding the world of DeFi is very important for cryptocurrency traders. Apart from the above-listed ones, other metrics such as use cases, project team, and on-chain analysis indicators such as unique address counts can be pivotal in understanding and buying a token. Volatility is common ground in cryptocurrencies, and you should carefully analyze these metrics to avoid buying a scam project or 'buying the top.'
We hope you find the given list of indicators useful and valuable. Do you use any other indicators while investing in a DeFi project? Kindly let us know in the comments below. All the best!