How Investors Can Weather the Bitcoin Storms

By Vladimir Smerkis

Everyone knows that crypto-currencies (CCs) are one of the hottest investment topics out there at present with extraordinary profits being enjoyed by many astute investors.

Also generally acknowledged is that the CC marketplace is very volatile. While the general tendency is for major crypto-currency denominations to show steady appreciation, there have been occasional heart-stopping plunges in value. Even the poster-child of the CC revolution — Bitcoin, has experienced over ten major but brief plunges in value during its nine years of existence — about one a year.

For the long investor, buying stocks and seldom reselling them, such plunges are an annoyance, but with the drops in value typically then being followed by a climb back up to the previous peak and then on upwards beyond, the losses are hypothetical and so not directly impactful, as long as there is no need to sell during a dip.

However, some investors seek out falls in value as representing an additional profit opportunity, using one of two strategies to profit from these occasions.

The first strategy is to buy up the CC as it falls in value, with the assumption being the drop is merely a technical adjustment rather than a valid revaluation. In such a case, there is a chance (but never a certainty!) that this is a great opportunity to buy the CC at an unusually low price compared to its recent trading history, and compared to its projected future return to positive territory.

When investors do this, they are of course confronted with the challenge of knowing when the optimum point is to buy — when will the value stop dropping and start rising again? Leave it too late, and the opportunity might be gone as quickly as it appeared.

A common strategy is to ‘average’ one’s portfolio by buying some CCs when values drop by a certain amount, and then more if values drop by a further certain amount, and so on. This is conservative rather than aggressive, but also more safe than risky.

For example, if we consider a crypto-currency that had been rapidly rising in value from $100 per token up to $1000, and if when reaching the $1000 point, its value started to drop again — down to $900, $800, $700, before reversing at $650 and returning back up to $1000 and then continuing its previous upward climb, an investor might buy some shares when the currency had lost 10% of its value, more if the value dropped by 20%, and so on.

In this case, the investor would have bought holdings at $900, $800 and $700, and if in equal amounts, that would see an average value of $800 per token. That’s not the same as buying at exactly the bottom ($650), but it is close to impossible to know when the bottom happens and the recovery starts. At least the investor has secured some currency during the brief drop in value.

There are also, of course, more sophisticated ways of setting the trigger points and investment amounts, on both the fall and recovery of a CC value.

The other approach is to short-sell a crypto-currency. This is essentially the same scenario as with traditional stocks, and involves selling tokens you don’t yet own, then buying them at an agreed future date to match the tokens already sold, and hopefully at a lower price. Not all investors appreciate that CCs can be short-sold, in a manner analogous to short-selling regular shares on regular exchanges.

Short selling works when the value of the CC is dropping. First, you borrow some tokens from another party. Then you sell them — say at $1000 each, to an investor who hopes the tokens will go up in value. You can then pick and choose when you buy tokens to give back to the person who lent them to you.

If, during the time between when you sold the tokens and then buy them to give back, the token value drops and you buy them back at $900, then you’ve made a profit of $100 per token (lower transaction costs, of course). But if the price of the tokens rises rather than falls, you’ve lost money.

Only some exchanges allow investors to short-sell CCs, because this requires additional functionality and more careful regulation of participants. There is a risk that needs to be prudently minimized to prevent fraudulent selling of tokens that an investor doesn’t have and can’t obtain. This is more a risk in a traditional market, because one of the happy side-effects of blockchain technology is that the risk of non-delivery of tokens is almost completely zeroed out.

Crypto-currency exchanges that allow for short selling include better known ones such as Poloniex, Bitfinex, and Kraken.

Typically what happens is that the person you are borrowing the tokens from requires you to have a certain percentage of the value of the tokens on account. So (in simple terms), as long as the tokens don’t go up in value beyond the amount of funds you have on deposit, their risk is covered.

From your perspective though, if the lender/broker requires you to simply have a 50% deposit, that means for every $1 you are investing, you can actually buy $2 worth of tokens. This ‘leverage’ can result in much greater returns on your money — but only if things go well.

If they don’t go well — in this case, if the tokens go up in value, your losses will also be at twice the rate they’d otherwise be.

There’s an unkind mathematical element in all of this as well. Clearly, in any short scenario, you run the risk of losing every penny of your investment (in theory, even more, but this is usually prevented by the broker urgently closing your position well before then so that their role in the middle is not under threat).

But what is the maximum amount you could actually earn? While there’s no limit on your percentage loss, there’s a clear limit on your percentage gain. In the case of tokens you short at $100 with a $50 deposit/margin, then the most you could ever receive is a $100 return for each $50 of deposit/margin — a doubling of your money, plus the return of your principal too, and less transaction fees.

If the margins are lower — if you only have to keep 40% of funds on deposit, then your return gets better — now you could get $100 for each $40 invested, plus the $40 back. And so on.

Oh, about those transaction fees. They’re higher than you’d expect. When you borrow the tokens for your short sale, the person lending them to you charges interest. The rates vary depending on the token, the exchange, and various other factors, but generally they seem to be at least 2%, per month, on the original value of the tokens you borrowed.

So, if you’re a classic portfolio investor, buy some crypto-currency type tokens, and hold on to them for an extended period, in the hope of overall increases in their value.

If the market is dropping, and you expect it to turn around, considering buying tokens during their fall in value in an averaging strategy.

Thirdly, if you think the market will soon start to drop, short-sell some tokens now and then buy them when you think the market has dropped about as far as it is going to.

So, for an astute, well-informed, active investor, it is possible to make money no matter which way the market moves.