Playing the Bitcoin Lottery
With Bitcoin blasting past US$9,000 in as many days, some traders have taken to snapping up “cheap” options should the world’s biggest cryptocurrency “moon.” But could such strategies benefit retail investors as well?
Timothy Graham, a 65-year-old retiree lives on a modest pension. From his white stucco house in a leafy suburb outside of Birmingham, Alabama, Graham has a few low-cost hobbies to bide the time.
Ever since his wife of thirty years passed away, Graham spends the time gardening and fishing, but what he really enjoys most is his weekly visits to his neighborhood bodega to buy a stack of Powerball tickets.
But given his modest means, Graham’s Powerball habit is by no means cheap. Spending no less than US$50 for each visit, a US$200-a-month habit.
“It gives me a chance to get out as well, talk to the people in the neighborhood. And you never know, it’s like buying hope.”
And hope, at least statistically-speaking, is all that Graham is buying.
At US$2 a piece, the odds of winning the jackpot at Powerball are 1 in 292,201,338 — or 1 in 292.2 million.
To put that number in perspective, you’re more likely to do any or even all of these things in your lifetime than ever hit the Powerball jackpot:
- Winning an Oscar (1 in 11,500)
- Winning an Olympic gold medal (1 in 662,000)
- Being crushed by a meteor (1 in 700,000)
- Dating a supermodel (1 in 880,000)
- Eaten alive by a flesh-eating bacteria (1 in 1 million)
- Being hit by lightning (1 in 10 million)
- Being killed in a plane crash (1 in 11 million, unadjusted for Boeing 737MAX-8)
- Becoming an astronaut (1 in 12 million)
Yet somehow, that doesn’t stop Graham and the legions of other hopefuls from buying Powerball tickets, because every ticket represents at least 1 chance.
The Bitcoin Powerball Jackpot
And so it seems when it comes to Bitcoin.
With Bitcoin’s recent resurgence, some hopeful investors are betting that this time the Bitcoin bull is back for real.
But is it?
In 2017, during the height of the cryptocurrency craze, BlockTower Capital CIO Ari Paul, bought US$1 million worth of options on LedgerX, a cryptocurrency derivatives exchange and clearinghouse, betting that Bitcoin would hit US$50,000.
These options would eventually expire worthless last December.
But before you think that Paul had made a mindless one-way bet on Bitcoin, speaking to the Wall Street Journal, Paul claims that the options he purchased were as part of a bigger transaction, which on the whole was modestly profitable, cautioning,
“I certainly would caution nonprofessionals against trading options.”
But that is precisely what seems to be happening once again.
As Bitcoin has roared past US$9,000, traders (or speculators) are starting to pour into more and more speculative bets on Bitcoin yet again.
On May 23, an unidentified trader bought US$135,000 of options on LedgerX, betting that Bitcoin would hit US$50,000 by June 2020. The 30 options, according to trading records at the U.S.-regulated Bitcoin derivatives exchange, will expire worthless in June 2020, if Bitcoin fails to reach that level.
But if Bitcoin does surge past US$50,000, the returns on the trader’s investment would be enormous .
Yet unlike Powerball, the odds of Bitcoin ever hitting such levels are hard to calculate.
For starters, Powerball exists in a highly controlled environment — the number of possible combinations is inherently calculable and therefore the odds of winning are deterministic.
In statistically-based sciences such as computer science and physics, a deterministic system is one where no randomness is involved in the development in the future states of the system.
While the winner at Powerball may be random, the odds of any specific ticket winning doesn’t change.
In other words, a deterministic model will always produce the same output from a given starting condition or initial state.
So it is for Powerball.
It doesn’t matter how many people purchase Powerball tickets, because the odds or any single ticket winning are exactly the same.
Buying more Powerball tickets increases the odds of an individual winning the jackpot, but it doesn’t change the odds of any individual ticket actually winning the lottery.
Such environments are what some observers have termed “kind” environments, where input and feedback are almost instant and the rules clearly defined.
Not so with cryptocurrencies.
Unkind Assets with Unpredictable Rules
As unconstrained assets, there are no clearly defined rules governing the price of cryptocurrencies — being purely set by market demand and supply.
Cryptocurrencies also do not exist in a controlled environment.
The blockchain may follow a strict set of protocols, but what determines Bitcoin or any cryptocurrency’s price can be subject to manipulation and market madness, or worse still, both.
And because unlike Powerball, it is entirely possible to manipulate the prices of Bitcoin and indeed many other cryptocurrencies — buying options is fraught with uncertainty and risk.
Yet despite these risks, Juthica Chou, LedgerX co-founder and COO has reported a revival of activity on the Bitcoin derivatives market, noting that Bitcoin call options with strike prices at US$25,000 have suddenly come back in vogue at LedgerX.
And it’s not just been at LedgerX that speculative bets on the rise of Bitcoin have occurred.
Last month, Amsterdam-based Bitcoin derivatives exchange Deribit, reported that traders had started buying Bitcoin call options (the right to buy at a given price) that would pay off only if Bitcoin rises past US$36,000 — marking the first time in months that anyone had traded options at such strike prices.
According to Josiah Hernandez, CIO at Satoshi Capital, a cryptocurrency trading firm,
“When you get these bull markets, people get a little excited and they start making more and more aggressive trading decisions.”
That goes without saying, but “aggressive” is really a euphemism for “speculative.”
To be sure, options have their value.
Too Many Options, Not Enough Solutions
Whether you’re a hog farmer or grow soybeans, options or futures provide a degree of certainty for the price at which you will be able to ultimately sell your produce at.
The certainty provided by derivatives based on key commodities is critical for keeping the supply of all of the raw materials necessary for the pursuit of modern life.
Whether it’s industrial metals or energy, orange juice or wheat, producers need to know the price that they can sell their produce at in the future, to manage their means of production for this season, as well as future seasons.
So it is (to some extent) when it comes to Bitcoin.
By securing a price for the future, an industrial-level Bitcoin miner can theoretically plan out their production cost and investment for today.
Or so it would seem theoretically.
Because unlike futures contracts in the commodities market, many of these so-called options and derivatives contracts, even those on the Chicago Board of Exchange and Chicago Mercantile Exchange do not specify for the physical delivery of Bitcoin.
In other words, quite the opposite from acting as an effective hedging strategy for Bitcoin miners or providing certainty for producers, such derivative contracts, in particular options contracts, are actually fueling speculative market behavior and adding to Bitcoin price volatility.
So if they are of limited value to Bitcoin miners, how then do Bitcoin options help in trading?
For one, cryptocurrency traders looking to short Bitcoin, particularly when prices bubble up, need also to cater for corner cases — externalities if you will — and “black swan” events which could leave them on the hook for large losses if they get their bets wrongly.
Say for instance a trader thinks that Bitcoin at US$9,000 is at a top and expects it to plummet back down to US$5,000 within the next year or so, a trader could buy a put option (the right to sell) with a strike price at US$5,000 (ideally US$5,000 plus the cost of the option) and if Bitcoin does dip to US$5,000 or less, the option is what traders call “in the money.”
An option is in the money because the right to sell Bitcoin at the price is presumably far in excess of the amount paid for the option.
So say the call option to sell at US$5,000 costs US$50 and Bitcoin has plummeted to US$3,000, the trader now can exercise the option, and pocket the difference, US$2,000, less the cost of the option, US$50 for a profit of US$2,950 on a US$50 investment — a return on investment of 5,900%.
But wait, there’s more…
If a trader instead expects that US$9,000 is just the beginning of a Bitcoin bull run, then they can buy a call option (the right to buy) Bitcoin at a future date, say US$50,000.
And if Bitcoin then trades at say US$100,000, the trader holding the call option at US$50,000 is also “in the money,” being able to buy Bitcoin at US$50,000 and being able to sell it at US$100,000 on the market, pocketing US$50,000 less the cost of the option.
The price paid for the option is called a “premium” and the trick is deciding what that “premium” should be.
In the 1990s, Long Term Capital Management or LTCM thought they had the art of figuring out how to price options down to a magical formula — something which ultimately imploded LTCM thanks to what were then considered “black swan” events, events thought of as so unlikely, LTCM piled the options high and sold them off cheap.
But given that the cryptocurrency markets are full of “black swan” events, how does one accurately price options anyway?
There are two main factors at play when it comes to pricing options — time frame and price prediction.
Timing the Market
To begin with, regardless of direction, it’s hard to determine the time frame for when Bitcoin or any other cryptocurrency for that matter is likely to move.
There have been many recorded instances of what could be considered “news” that ought to have resulted in bullish “buy” signals for Bitcoin but which ultimately resulted in nothing.
There have also been many recorded “bearish” signals that ought to have resulted in “sell” signals with limited impact on Bitcoin price movement.
Unlike stock markets and commodity markets, Bitcoin simply hasn’t been around long enough to discern seasonality, nor do there exist sufficient fundamentals to determine clear causality between events and price.
For example, there is an adage in the stock markets “sell in May and go away” and while that saying may no longer hold true, for a long time the markets perpetuated that self-fulfilling propehecy — no such equivalent exists for cryptocurrencies.
Similarly, some pundits had claimed that Bitcoin and other cryptocurrencies ought to have seen a boost towards the end of 2018, the same way it did in 2017, but this never happened — crypto winter turned out to coincide with the northern hemisphere’s winter and it’s only now that we’re seeing a spring thaw.
Given that it’s hard to predict when Bitcoin will rise or fall, it becomes obvious that a longer time frame is preferred when it comes to Bitcoin options, especially if the strike prices are really “out there.”
For instance, from now till 2020, there is certainly more than a non-zero chance that Bitcoin could hit US$50,000 just as there’s almost certainly a higher than non-zero chance Bitcoin could plummet to US$500.
That doesn’t mean that it will definitely hit US$50,000, but given a year and the huge volatility that Bitcoin is prone to, the LedgerX options, at US$4,500 a piece, may not be seen as a purely “hopeful” bet.
Plus, it is unclear whether the trader who bought the LedgerX options took out other options or indeed acquired Bitcoin at its current price level, or even cheaper.
Meaning that unless and until a trader’s entire portfolio is revealed, such sensationalist headlines of Bitcoin option purchases, while good for clickbait, provide limited information as to a trader’s overall strategy for profiting from Bitcoin options, or even whether such options are reflective of sentiment towards Bitcoin in general.
Bearing in mind that unlike other markets, Bitcoin and other cryptocurrencies trade 24/7 all-year-round, meaning that market cycles (if any exist) will be much more condensed than those of financial markets, it’s safe to say that a year in Bitcoin is comparable to three in the financial markets.
And because Bitcoin trading in particular, tends to be automated, the considerations are different when it comes to determining time frames with respect to the pricing of options as opposed to say trading in pork belly futures on a commodities market.
We Never Learn From History and That’s Probably A Good Thing
Part of the process of trading options also involves studying the historical pricing of the underlying commodity of the option in question.
And to that end, the trading history of Bitcoin is hardly helpful because large volume in trading terms have only been witnessed in the last 2 years or so.
But I would suggest that a one-year time frame for a Bitcoin option is thebest compromise because unlike the previous Bitcoin bull run, cryptocurrencies are already in the public consciousness.
Institutional interest (as opposed to participation) in cryptocurrencies has increased, so the odds of participation both from high net worth individuals, family offices and institutions is higher rather than lower.
Increased interest and eventual participation, though not a given, means that increased volatility is a distinct possibility. Where that volatility will lead is another thing altogether.
But in general, more market participants has a tendency to push prices upwards.
And given that Bitcoin is an unconstrained asset, with no physical underlying commodity underpinning it, speculation will more likely than not have a tendency to push prices upwards.
And nothing quite drives a bull run like FOMO (fear of missing out), something that even the very richest people are not immune to.
Against this backdrop, a Bitcoin option with a time horizon of a year is not so unreasonable, but less than that? That would be anyone’s guess.
Pick a Target, Any Target
Then there’s the issue of target price.
Is Bitcoin overpriced and set to tumble or is it underpriced and set to soar?
A trader has to pick a position for a Bitcoin option and he or she has a 1 in 2 chance of being right.
Of course a trader can also pick both sides — otherwise known as hedging and depending on the premium for the options, can still make a tidy profit by balancing both put and call options.
There are also a wide range of exotic option trading strategies such as covered calls, married puts, protective collars, long straddles and long strangles, but I’ll leave those for another day.
But for those trying to make simple one-way bets, picking a side is not only inevitable, it’s a prerequisite to profit.
So what direction is Bitcoin heading in?
If I were the sort that were prone to divinity, I would hazard a guess, but there just simply aren’t any rational or quantitative tools to pick a target price for Bitcoin or any other cryptocurrency outside of a very constrained time frame.
Minute-to-minute, it is relatively easy, using automated algorithmic trading. to determine a price target for Bitcoin versus the dollar and to literally pick pennies off the floor, making small scalps to trade Bitcoin profitably, regardless of market direction.
Outside of such constrained time frames, a target price is in the realm of clairvoyance, a skill which I do not profess to possess.
Which is why a year out, it’s entirely impossible to say where Bitcoin will be.
Thomas Lee of FundStrat was repeatedly ridiculed on the major networks for calling for Bitcoin at US$25,000 throughout the last two years, even as Bitcoin came tumbling down.
Yet it’s entirely possible that Lee didn’t get his price target wrong, he may have just gotten his time frame wrong.
There are no comparables with which to base Bitcoin on, no precedent and no juxtaposition, which makes calling both price and time frame on Bitcoin such a exercise in futility.
Pricing options in the financial markets for which things like underlying demand for product and market cycles have been established for the better part of a century are a cakewalk when compared to trying to price options for cryptocurrencies and in particular Bitcoin.
Determining the right price for a Bitcoin option is not just like trying to hit a moving target, it’s like trying to hit a moving target facing the wrong direction while blindfolded.
So unless a trader is buying Bitcoin options as part of a complete and healthy trading strategy, they’re buying something slightly less than a lottery ticket — at least for Powerball the odds are calculable.