Bitcoin (BTC) has been on a remarkable run since late 2023, reaching new all-time highs above $40,000 and attracting more institutional and retail investors. However, a technical indicator that accurately predicted the start of this rally is now signaling a possible reversal in the near future.
The indicator is called the Bitcoin Difficulty Ribbon, and it is based on the changes in the mining difficulty of the network. The mining difficulty is a measure of how hard it is to find a new block and earn the block reward. It adjusts every 2016 blocks, or roughly every two weeks, depending on the hash rate of the network.
The Difficulty Ribbon consists of nine exponential moving averages (EMAs) of the mining difficulty, ranging from 9-day to 200-day. The idea is that when these EMAs converge or compress, it indicates that miners are under stress and may have to sell some of their coins to cover their costs. This creates downward pressure on the price and precedes a period of consolidation or correction.
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Conversely, when these EMAs diverge or expand, it indicates that miners are profitable and can hold on to their coins. This reduces the selling pressure on the market and precedes a period of expansion or rally.
The Difficulty Ribbon was first introduced by Bitcoin analyst Willy Woo in 2019, and it has proven to be a reliable indicator of major trend changes in the market. For instance, it signaled the start of the 2017 bull run when it expanded in January of that year, and it also signaled the end of the 2018 bear market when it compressed in December of that year.
Most recently, it signaled the start of the current rally when it expanded in November 2023, after Bitcoin broke out of a multi-month consolidation pattern. Since then, Bitcoin has surged more than 300% and reached new highs above $120,000.
However, the Difficulty Ribbon is now showing signs of compression, which could indicate that the rally is losing steam, and a correction is imminent. The compression is not yet confirmed, as it requires at least two consecutive downward adjustments in the mining difficulty. The next adjustment is expected to occur around January 28, 2024, and it is projected to be a negative one, according to BTC.com.
If the compression is confirmed, it could mean that Bitcoin is entering a new phase of consolidation or correction, similar to what happened in mid-2019 and mid-2020. In both cases, Bitcoin experienced a sharp drop of around 40% after the Difficulty Ribbon compressed, followed by a period of sideways trading for several months.
Of course, this does not mean that Bitcoin will follow the same pattern exactly, as there are many other factors that influence the market dynamics. However, it does suggest that traders and investors should be cautious and prepared for increased volatility and potential downside risks in the near term.
The Difficulty Ribbon is not a perfect indicator, and it can sometimes give false signals or lag behind the actual market movements. Therefore, it should not be used in isolation, but rather in conjunction with other indicators and tools that can provide more context and confirmation. As always, do your own research and exercise due diligence before making any investment decisions.