How to Analyze Cryptocurrency: The Basics

How Does Cryptocurrency Work?

Bitcoin and other cryptocurrencies are digital currencies that allow people to send and receive payments without involving third parties. They are also used by many people as speculative investments.

Cryptocurrencies are created using programs and distributed systems that store information on blockchains. Blockchains are similar to distributed ledgers, and information regarding ownership is transferred using automation. Other than initiating and accepting monetary transactions, creating the software, building the systems used, and installing applications on devices or systems, humans are not involved.

Cryptocurrencies are distributed or given to owners in several different ways. For example, Bitcoin is rewarded to a network participant after their mining program successfully solves a cryptographic puzzle. Ether—the Ethereum network’s token—is awarded to participants as fees for validation and processing work done.

Nearly all cryptocurrencies can be purchased on a cryptocurrency exchange, which is how most owners acquire their tokens. Before buying a cryptocurrency for investing purposes, it’s best to learn how to analyze it so you can better decide which to buy.

1. Review the White Paper

Most crypto projects provide a white paper, which helps define the objectives and technical details about the blockchain and its cryptocurrency’s role. True white papers contain terms and language data scientists, programmers, and developers understand. For instance, Solana has a whitepaper that describes how the blockchain will work and what the token is used for.

Cybertruck’s white paper, on the other hand, does not—it is a flashy website that talks about the potential for building a community. A disclaimer at the bottom of the webpage states, “$CYBERTRUCK is a meme coin with no intrinsic value or expectation of financial return. There is no formal team or roadmap. The coin is completely useless.”

An example of a true cryptocurrency scam is Bananacoin. This now-defunct cryptocurrency was an initial coin offering that offered tokens in exchange for money. The project claimed it would use the funding to maintain a banana farm in Laos and that the coins could be exchanged for equal-value Laotian bananas in the future.

A cryptocurrency with utility or a reason to exist should have a white paper that clearly defines the project’s goals, how it will achieve them, and how the cryptocurrency will function. Legitimate white papers define a problem being solved with the blockchain and token, and this problem and solution should be crystal clear to investors.

2. Research the Team

Cryptocurrencies are typically created by a team of founders and software developers who help create the solution to a problem. To better understand how a project could perform, you should research the professional experience of the project team. 

This may include reviewing LinkedIn profiles to learn about the professional background of any of the technical or leadership staff and the previous projects that the team members have launched. Also, the “About” page on any cryptocurrency’s website should clearly articulate who is helping build the project and what their expertise entails.

A red flag would be a team of anonymous founders or developers who don’t reveal their identity publicly or an inexperienced team that has not built or scaled any projects in the past.

3. Learn About the Leadership

Crypto projects with the potential to make a difference have a clearly defined executive team that handles its execution, financials, and marketing. Learning more about who is leading a cryptocurrency team can give insight into the probability of success for a project.

Here are a few questions to ask when researching a crypto project’s leadership:

• Do they have a history of successful leadership positions?
• Are they reputable/well-known leaders?
• Do they have a history in the crypto industry? Is it good or bad?
• Are they public-facing or anonymous?

While some projects with anonymous founders, such as Bitcoin, are launched with good intentions, others are not. A cryptocurrency is likely not legitimate if its leadership is sketchy or if it avoids important topics.

4. Get to Know the Community

Most cryptocurrencies are community-driven projects that require a strong, supportive community to grow. Learning about a cryptocurrency community can help you gauge whether a project will succeed or is pure hype and speculation.

Joining the community’s Discord or Telegram channel can help you learn more about it, as well as get your questions about the project itself answered. If a large community base is well-organized and frequently promotes the project, it could be a sign that a cryptocurrency has the potential to grow. Communities should be discussing issues with the blockchain and improvements that could be made or have other similar discussions—in addition to the regular conversations that might occur between people with similar interests. If all you find is hype and pumping, it is a good bet that the cryptocurrency project is not legitimate.

5. Understand the Technology

Cryptocurrencies are a new concept built on distributed systems that have existed for decades. The original intent behind them was to remove human involvement (and thus corruption, mistakes, and third-party profits) from financial systems. If you can gain even a partial understanding of how blockchains work and can be used to solve problems, you’ll have the upper hand in deciding whether a cryptocurrency is worth investing in.

However, you don’t need to know how to program or maintain a blockchain—but learning what a token is, what the blockchain does, how it is maintained, what is stored on a blockchain, and how the blockchain is interacted with by users is essential for would-be investors. Otherwise, you’re only speculating on prices and hoping the coin becomes popular.

6. Understand the Vision

Cryptocurrency creators should have a clear vision of their goals, with a road map that estimates how they will get there. This should be readily available in the white paper and on its website. The vision of a crypto project should give enough details for you to understand what problems it is solving and the potential user base.

For example, if a website has statements like “cryptocurrency is the future” but does not define or articulate a clear vision for how the cryptocurrency solves a specific user problem, it is a red flag.

7. Review the Road Map

The road map for a cryptocurrency project is a timeline of events that shows its expected progress. Typically shown on a line graph, the road map should have clear and concise milestones broken down on a quarterly basis, all moving the project toward a predefined set of goals.

The road map may be available in the white paper, though most crypto project timelines are ever-changing and are listed on a website. If there is no defined road map, or if the milestones are too generic (or based on money raised or earned), it is a red flag.

8. Learn the Tokenomics

The term “tokenomics” refers to the distribution, circulation, and total supply of a given cryptocurrency. This is important, as it affects the overall price of a cryptocurrency over time. Similar to shares of stock in a publicly traded company, the price of a given cryptocurrency reflects supply and demand. The more shares there are, the more demand there needs to be to increase the price.

Here are three important data points to review before investing in any cryptocurrency:

• Circulating supply: The cryptocurrency currently in the market
• Total supply: The total amount of cryptocurrency issued, including those that have been burned (removed from circulation)
• Maximum supply: The maximum amount of tokens that will ever be issued

All three of these statistics can greatly affect the price of a given cryptocurrency, so understanding supply is essential for cryptocurrency investors.

Some cryptocurrency projects use uneven token distribution methods to try and influence prices. Reviewing the token unlock schedule can help you understand how the tokens will be distributed and to whom they will go. Projects that give the founders a large portion of tokens at release should be viewed skeptically.

9. Review the Data

Cryptocurrency prices are known to swing up and down wildly. One reason for these wild swings is that investors do not want to be left out of the next big price jump, nor do they want to be left holding a cryptocurrency that has dropped significantly in price (unless they are very bullish about it).

Users influence prices as well, paying for cryptocurrency at the going market rate, but this activity is much less significant an influence than investing and trading.

Cryptocurrency prices also react, sometimes explosively, to news and events because of investor anticipation. For example, Bitcoin halvings are believed by many investors to be events that increase its price because there is a reduction in the rate at which new coins are introduced. However, what’s really causing the price changes is demand because investors associate the event with a decrease in available new coins—so they start buying more, causing the price to increase.

The price of the cryptocurrency you’re reviewing should follow the same trends other cryptocurrencies have because traders and investors will generally treat them the same as they do other investments. Prices that seem out of place should raise an eyebrow.

How to Avoid Cryptocurrency Scams

Because most cryptocurrencies have market value, they have naturally become a tool used by scammers and thieves. There are many easily identified cryptocurrency scams, but some are very difficult to spot.

The analysis steps listed above are the best place to start when trying to determine whether a cryptocurrency is legitimate. Here are some other tips for staying ahead of scammers and thieves.

Never Share Your Information

Legitimate users, developers, and exchanges will not contact you for usernames, passwords, and pins. Regulated exchanges offer private key storage solutions, so you might be asked to transfer your keys to them if you choose their storage, but most entities will not ask you for your keys or information.

Use Regulated and Reputable Exchanges

Decentralized cryptocurrency exchanges are popular because they provide a connection to others without asking for personal information—but this adds risk. Centralized and regulated exchanges verify user identities and offer more protection on their platforms. They are not 100% safe, but they are more safe than decentralized exchanges, at least for most users. These exchanges generally vet the cryptocurrencies they list.

Beware of Social Media

Social media is a favorite tool for scammers because they can quickly and easily target the most people. If you’re contacted by anyone about new cryptocurrencies or services related to them, it’s best to avoid them. Exchanges and legitimate users will not contact you via social media.

Other Important Tips

• Avoid Free Money: Nothing is free, so it’s best to avoid cryptocurrency teams giving away their tokens.
• Guaranteed Returns: No one can guarantee returns on an investment. This should be a clear indicator of a scam.
• Verify the Apps: Applications on app stores can be fake or include malware, so it’s best to ensure you use apps that have been thoroughly vetted and reviewed. Also, only download apps from sources you trust.
• Avoid Giveaways: There are some valid reasons for cryptocurrency giveaways, such as a hard fork into a new blockchain and token. But most giveaways are schemes to draw your interest and money.
• Avoid Initial Coin Offerings: In most developed countries, initial coin offerings (ICOs) are regulated and must be registered with the appropriate authority. If they are not, it’s best to avoid them.
• Cold Calls: Legitimate cryptocurrency businesses or developers will not call you to solicit your involvement, money, or private keys. If you do receive a call like this, simply hang up and contact the entity where you purchased or stored your cryptocurrency.

The Bottom Line

A cryptocurrency analysis involves examining all the available information about a digital asset. Understanding and researching the topic helps you to determine why it’s priced the way it is and whether it is worth investing in.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our warranty and liability disclaimer for more info. As of the date this article was written, the author does not own cryptocurrency.