Taking the Bite out of Bitcoin Volatility

On 17th December 2017 Bitcoin closed on the Bitfinex exchange at $19,210. Last week, a gruelling six months later, Bitcoin bottomed at $6,443.[1] That is a drop of -66%. It is not the largest fall in Bitcoin’s history. That was a -83% loss of value ending 14th January 2015. Nor is it uncommon. Bitcoin has now lost more than -60% of its value seven times in seven years. If you hold Bitcoin what can you do about this volatility?

[1] https://www.quandl.com/data/BITFINEX/BTCUSD-BTC-USD-Exchange-Rate

Bitcoin has lost > -60% of its value 7 times in 7 years

I suggest there are four things you can do to take the bite out of Bitcoin’s volatility:

B for Buy
I for Ignore
T for Trade
E for Enhance

B is for Buy
 
 Let’s start with B for Buy. The golden rule of every professional investor is to buy low and sell high. Robert Kiyosaki, author of the all-time bestselling personal finance book, Rich Dad Poor Dad, moved from city to city to take advantage of where property prices were at their lowest. With Bitcoin lower than it has been since October 2017 this could be a very good time to buy the coin.

However, as Kiyosaki points out in his book, the key to being a successful investor is discipline and self-belief. Bitcoin may not recover for a year or two. It may never recover. There are strong psychological reasons why many people are not professional investors.

But before you decide not to buy Bitcoin at this time consider this: you may have, even unwittingly, already done an analysis of the fundamentals that determine Bitcoin’s price and concluded they are sound.

Market fundamentals are what investors look at before deciding to invest. Because he is a property investor Kiyosaki looks at the general economy as well as interest rates, mortgage defaults along with other factors to gauge whether it is a good time to buy. Even without realising it, many people may have already convinced themselves of that the fundamentals are right for Bitcoin without having formally come to this conclusion.

That is to say, if you are interested in crypto-currencies in general and Bitcoin in particular, you may have arrived in this fledgling market out of concern at the continued loss of value of fiat currencies. You may believe that the continued printing of money by governments is not sustainable. You may sense that the 1,900 times increase in the supply of US dollars over the last hundred years cannot have a happy ending. [1] You may have seen the Forbes article that suggested the average life expectancy of a fiat currency is 27 years.[2]

[1] http://money.visualcapitalist.com/buying-power-us-dollar-century/

[2] https://www.forbes.com/sites/ralphbenko/2011/08/29/u-s-elites-begin-to-confront-the-paper-dollar/#17d962582f15

Increase in supply of US dollars since 1960

If your interest in Bitcoin stems from analysis like this then you have in effect concluded that the fundamental environmental factors around Bitcoin are ripe for the coin’s continued increase in value. If you hold such a view, then buying Bitcoin when it is low makes good sense. Despite volatility the fundamentals are sound. The current price of Bitcoin makes it a good time to buy irrespective of whether this is the true bottom of the market because the fundamentals that brought you to Bitcoin have not changed.

I is for Ignore

On the other hand you may agree with legendary investor Warren Buffett that Bitcoin is “probably rat poison squared.”[1] Buffet believes that Bitcoin is an asset based on pure speculation:

“When you buy non-productive assets, all you’re counting on is that the next person is going to pay you more, because they’re even more excited about another next person coming along,” Buffett said. “The asset itself is creating nothing.”[2]

[1] http://money.cnn.com/2018/05/07/investing/warren-buffett-bitcoin/index.html

[2] http://time.com/money/5267647/warren-buffett-bitcoin-invest/

Warren Buffett: Bitcoin based on pure speculation

Buffett is not alone is this view. Bill Gates is against Bitcoin. UBS Chairman Axel Weber said that Bitcoin and other cryptocurrencies were speculative, risky and “not an investment we would advise”.[1] Many others in the financial world would agree with Weber. JPMorgan Chase and Co. CEO Jamie Dimon claims that Bitcoin investments “won’t end well” for investors.[2]

If Bitcoin is a purely speculative asset based on nothing then its volatility can be seen as a sign of this lack of inherent worth. In this context the best strategy to manage this volatility is to exit the market and never return.

T is for Trading

Professional traders, as opposed to professional investors, require volatility in order to profit. They can be agnostic as to the market they are trading. To them it makes no difference whether they are trading sugar or oil, the US dollar against the Euro or Bitcoin. The only thing they cannot tolerate is a flat market with little or no volatility. For if the price does not change then they cannot gain if the bets they place on direction prove to be correct.

For a professional trader then the volatility of Bitcoin is a godsend. Few if any non-crypto markets display anything like the volatility of Bitcoin over an extended period of time. With good timing, the current fall in Bitcoin prices, by betting on this fall, called shorting, would have been a period of enormous gain.

The Chicago Board of Trade has classified Bitcoin as a commodity and now lists Bitcoin Futures. It is possible to short a futures contract. One contract is equivalent to 5 Bitcoin.[3] At present the market is not very liquid with open interest of 2,135 for June 2018 (the most liquid month) compared with for example Henry Hub Natural Gas that has open interest of 193,551 for August 2018.

However it is not necessary to use Futures to short Bitcoin and take advantage of its down side volatility. Other options include:

Margin trading — many exchanges such as Kraken and CEX allow you to borrow money to short Bitcoin, in effect increasing the gains or losses of taking such a position.

Binary Options Trading — “A binary option is a simple type of option that is valued according to a true/false statement. For example if the price of the underlying asset is above a certain level the call (long) option will pay 100, if it is below it will pay 0. For a put option the reverse is true.”[4] Brokers include IQ Option and Cryptobo.com.

The key to utilizing Bitcoin’s volatility by shorting is the accuracy of your bets. Traders use a variety of methods to evaluate the likelihood of falling prices. These can include fundamental analysis of market conditions that suggest Bitcoin is over-priced, or technical indicators based on volume, standard deviation of returns, Fibonacci numbers and others.

E is for Enhance

The project I am involved with represents a synthesis of B is for Buy and T is for Trading. Called Bitcoin Enhanced we are launching a token that tracks the price of Bitcoin except during periods when we forecast that Bitcoin prices are likely to fall. These forecasts simulate shorting Bitcoin. At the end of a forecast, if Bitcoin is lower, then the Bitcoin Enhanced price rises by the equivalent amount. There have been five forecasts since February 2018 when the project began and the Bitcoin Enhanced token is currently trading at a 69% premium over Bitcoin.[5]

Creating a token that utilises Bitcoin’s volatility in the form of forecasts has several unique benefits. First, people with no trading experience can directly participate in gains made from successfully forecasting from Bitcoin’s downside volatility. The forecasts are made by the system and the results, up or down, are reflected in the new price of the Bitcoin Enhanced token. The White Paper suggests an expected win rate of 60% of forecasts. As long as more percentage falls than percentage gains are forecasted the token improves on Bitcoin’s price while reducing its volatility.

Second, every investor understands the powerful effect of compounding. Compound interest calculators show the outstanding performance of assets where small gains, when reinvested, produce incrementally greater returns over time. Bitcoin Enhanced tokens incorporate this most venerated investment tool. Each forecast builds upon the results of the previous. This means that over time the gains of the Bitcoin Enhanced token can grow many times faster than the gains of Bitcoin if the forecasts are in general successful.

Already, with only 5 forecasts since February, this compounding effect can be seen in the way the Bitcoin Enhanced price is starting to diverge from the Bitcoin price. Back tested simulations since 2011, also on the website, shows what happens when such compounding continues for an extended period of time.

[1] https://www.theguardian.com/technology/2018/jan/23/bitcoin-ubs-chairman-warns-against-cryptocurrency-investment-currency-falls

[2] https://www.cheatsheet.com/money-career/powerful-people-love-or-hate-bitcoin.html/?a=viewall

[3] http://www.cmegroup.com/trading/bitcoin-futures.html

[4] https://en.bitcoin.it/wiki/Binary_options

[5] https://bitcoinenhanced.io/

Bitcoin Enhanced price (blue) diverging from Bitcoin (gold) through the power of successful forecasts and compounding. Source: https://bitcoinenhanced.io/

The two benefits of built in forecasts and compounding provide a viable option for people who believe that the market fundamentals for Bitcoin are sound and who want to also use the coin’s volatility to good effect.

So the key to taking the bite out of Bitcoin’s volatility rests first upon what you believe about Bitcoin. If you believe Bitcoin’s price will continue to rise then buy your Bitcoin when the price is low or consider Bitcoin Enhanced. If you are agnostic about Bitcoin, you can still profit from the volatility as a trader. And if you believe Bitcoin’s volatility is due to its lack of substance beyond speculation your best option is to cut your losses and sell the coin. Bitcoin Enhanced tokens are called BElieves because it is what you believe that counts.