Purple Valley Capital, Inc. Don is married to an emergency physician and has guest posted for WCI in the past about managed futures. He clearly has thick skin given the reception his last post here received. We have no financial relationship. Purple Valley Capital is NOT on the list of WCI recommended advisors. See my note at the end of the post for further information or perhaps just to satisfy your curiosity as to why this post was run on this site at all.]
Bitcoin Isn’t Suitable for Everyone
In the ten years since Bitcoin was invented, its price appreciated from less than one cent to over $19,000 per coin. In 2017 alone, the popular cryptocurrency doubled in value more than four times. But after reaching a peak in December 2017, the same month that Bitcoin futures were introduced, Bitcoin and Bitcoin futures tumbled over 70%. They are both currently worth about $6,000 per coin. While violent, the most recent fall in price is not new nor unprecedented—Bitcoin spot prices have actually experienced four drops of over 70% in its short lifespan, including a 93% drop in 2011. To say Bitcoin and Bitcoin futures are volatile is an understatement; they are some of the craziest markets that I have ever seen. Bitcoin markets are not suitable for everyone, and while I assume very few readers of Dr. Dahle’s blog have exposure to them (which is totally fine!), I do think that you may find the concept, and their price action, fascinating. Bitcoin, and its derivatives, have the potential to go down in history as some of the biggest financial asset bubbles ever. My goal is to offer some information about what Bitcoin and Bitcoin futures are, the risks of getting involved in such volatile markets, and how my firm approaches trading the futures market from a risk management perspective.
For some background, Bitcoin is a virtual currency (a.k.a. cryptocurrency) that was created in 2009 and is designed to work worldwide as a medium of exchange and store of value without a central repository or single administrator. The system is incredibly unique in that it is peer-to-peer, and transactions take place between anonymous users directly without an intermediary. All transactions are recorded in a blockchain, which is an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way. This underlying technology in and of itself, is an extraordinary achievement, and it is the core component of Bitcoin where it serves as the public ledger for all transactions. While over 1,000 cryptocurrencies have been created, Bitcoin was the first, and remains the most popular and widely used. Over 100,000 merchants and vendors accept Bitcoin as payment, and world central banks are currently evaluating cryptocurrencies as potential reserve currencies. Because of its increased popularity and fixed supply, Bitcoin’s price skyrocketed over the past decade (with extreme volatility), as investors and speculators rushed to get involved.
How to Buy Bitcoin
There are two main ways to gain direct access to the Bitcoin market. The first is through buying or selling Bitcoin for dollars or other fiat currency through one of the various specialized (but unregulated) exchanges. As an example, the largest such exchange in the U.S. is Coinbase. After buying Bitcoin, the coins are then stored in your “cold” (offline) or “hot” (online) cryptocurrency wallet to be sold or used at a later point in time. The prices of these Bitcoin are known as spot, or cash, prices. I must emphasize that, because Bitcoin is completely unregulated, the spot market has attracted bad actors who commit fraud, theft, and hacks, with very little recourse for the victims. The second method to gain access to the Bitcoin market is via the Bitcoin futures market, which is a product that was launched in December 2017 by the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME), both of which are regulated exchanges under the U.S. Commodity Futures Trading Commission (CFTC). Bitcoin futures derive their price from the underlying spot price of Bitcoin. The futures offer a way to gain exposure to the gains and losses of the market without owning the underlying virtual coin. While more regulated than the unregulated spot market, Bitcoin futures do have added risks that are associated with being a futures market—leverage, volatility, and complexity (see disclosures at the bottom of my article, per my regulators).
Bitcoin futures can experience significant price volatility, and thus margins may be higher and trading halts can be imposed making it difficult to enter or exit markets. Bitcoin futures trading involves a high degree of risk, potentially even more so than other futures markets, because of the risks inherent in the underlying spot market. Again, Bitcoin spot is completely unregulated, not recognized as legal tender in the U.S., extremely volatile, subject to cybersecurity risks, and difficult to value. My firm is registered to trade commodity futures products, so I trade Bitcoin futures, but I do not trade Bitcoin spot. I’d like to emphasize that while I do trade Bitcoin futures, it makes up a very small portion of my trading program’s activity. I also trade over 40 other commodity and currency futures markets. But for the purpose of this post, I am focusing on Bitcoin markets. Below are charts of both Bitcoin spot, and Bitcoin futures, with the Bitcoin futures chart having a much shorter time frame since they were only introduced last winter.
Why I Trade
While some people understandably elect to watch the price of Bitcoin and its derivatives from the sidelines, I’m cut from a different cloth. My temperament and interests attract me to hot volatile markets (commodity futures in particular), where I try to manage the risks and attempt to make trading gains from large moves. Managers who trade futures products, including Bitcoin futures, are known as Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs). My firm, Purple Valley Capital, Inc., has been registered as both since I founded it over ten years ago. I’ve traded my share of volatile futures markets over the years, but they pale in comparison to the Bitcoin futures market. I enjoy trading Bitcoin futures because I feel they are the perfect speculative market—demand is driven by human emotion (and faith, or lack thereof, in fiat currencies), supply is finite, and trying to find a fundamental value on the underlying asset is virtually impossible. Thus, the market is prone to having huge booms and busts, more so than most other markets.
My Trading Plan
While CTAs can trade a whole portfolio of various commodity and currency futures markets searching for large trends, Bitcoin futures are often the most volatile market in the commodity futures space. It is essential to allocate accordingly and have a bullet proof trading plan. Some essential aspects of a plan may include:
- Only allocate capital that you can afford to lose
- Properly size the position such that the volatility is normalized
- Have a clear plan for when (and at what price) you will exit with a win or loss
- Cut losses extremely quickly; ride winners
- Never turn a trade into an “investment” because it’s losing and you want to give it more time to “work”
- Don’t deviate from your plan
- Enjoy the ride
I feel that even the most volatile market in the world shouldn’t keep you awake at night if you’re properly allocated, understand the risks, and have a plan for when to exit with a loss or a win. Still, some people may choose to stay away from Bitcoin spot and/or futures, and that’s totally ok! As Warren Buffet says, “You don’t have to swing at every pitch.” But then again there are others, like George Soros, Paul Tudor Jones, and other global macro trend traders who feel bubbles and crashes offer the greatest opportunities to make the most money (but obviously have correspondingly elevated risk of loss too). The best risk managers figure out ways to manage the downside risk while retaining the upside on both their long and short trades. Volatility does not scare traders. We know that we need volatility to help spring us higher; our job is simply to try and limit the downside volatility while preserving the upside. As any successful trader will tell you, there’s no better way to do this than by cutting losers quickly and riding winners. Because of this paradigm, the majority of futures traders with any length of tenure are trend following in nature.
While my firm’s risk management strategy is reactive, systematic, and does not predict price direction, I can’t help but be fascinated by the Bitcoin and Bitcoin futures markets and wonder what will happen to them moving forward. I have an avid interest in financial market history and bubbles. The word bubble gets thrown around frequently, and everyone has their own definition. I think my view will be different than most, because in my opinion, the Bitcoin markets are not a massive bubble, but could still be one. I do think they undoubtedly have some ingredients of a bubble including a breakthrough idea, incredible price appreciations and collapses, enthusiasm, as well as rampant speculation. Cab drivers, co-workers and neighbors are talking about Bitcoin markets, and articles about them continue to pop up everywhere. But it’s still only in the very beginning stages of leverage, liquidity and mass adoption.
Most of my neighbors and friends don’t own Bitcoin or its derivatives, and I doubt many of you do either. The biggest bubbles affect almost everyone. Wall Street is still in the beginning phases of expressing interest. The futures market (which was only introduced last year) and ETFs (not yet approved) may help with this next stage of mass adoption. I do think Bitcoin could be on the path to becoming a bubble, and in the end when it eventually bursts, unfortunately lots of people and entities will get hurt financially due to over extension and improper risk management and position sizing. This was the case with the Tulip, South Sea, Technology, and Housing bubbles too. But to be mentioned alongside these historic bubbles, I think Bitcoin will have to be much more widely owned and affect many more people and institutions, both on the way up, and way down. It may sound crazy, but the main bubble part of the move could still be ahead of us. The recent 70% drop in Bitcoin spot and futures markets could actually be interpreted as a “normal” correction in a wildly volatile market. When it’s all said and done, I think the Bitcoin markets have a chance to go down in history as the largest financial market bubble ever simply based on the fact that, unlike all other prior bubbles, this is truly a global phenomenon and the supply is inelastic.
I hope this discussion was interesting and helpful for you. If you do decide to get involved in Bitcoin spot and/or futures, please understand the risks, because there are many. I would strongly urge you to either have a plan and allocate properly yourself, or utilize the help of a professional. The Bitcoin markets are a speculative beast that moves with ferocious velocity, and no one knows where they will move next.
From the Editor:
I don’t buy Bitcoin. I don’t view Bitcoin as a viable currency. I don’t buy futures. I don’t speculate. I don’t trade in the sense discussed in this article. I don’t use technical analysis. Like other humans, I am not particularly talented at predicting the future. Yet somehow, I am a multi-millionaire in my early 40s and am freed from the need to work for money ever again.
So, is trading Bitcoin smart or stupid? Wrong question. The question you should be asking is, “Is trading Bitcoin relevant to your life?” Almost surely not. This is one of many corners of the investing universe that you can safely ignore. There are no called strikes in investing. You can stand there at the plate all day waiting for a pitch you like to come by. Trading, speculating, and buying bitcoin are all pitches that I would let go right by.
Two points about Bitcoin that are worth understanding.
# 1 Bitcoin absolutely was in a classic bubble and that bubble has burst. Bubbles are sometimes difficult to identify while you’re in them, but they’re very obvious in hindsight, and Bitcoin had a bubble. It was the most impressive speculative frenzy of my investing career, and a pleasure to watch. Bernstein identified the following characteristics of a financial market bubble and warned that when you see at least 3 of the 4, steer clear:
- The asset becomes the subject of conversation at social gatherings
- People are quitting jobs to speculate in it
- Skeptics are met with anger
- Extreme price projections
By December of 2017, all four of those were in place as evidenced by the links. So it should be no surprise that the Bitcoin chart for the last year looked like the classic chart of a bubble.
Wow! You’d think that second chart was drawn AFTER the first one happened, but no, that second one has been around for years. At any rate, anyone who couldn’t see that there was a Bitcoin bubble, especially in retrospect, has no business managing their own money, much less anyone else’s. Now I have no idea where Bitcoin goes from here. Maybe it goes up. Maybe it goes down. Maybe it goes to zero. Maybe it goes to the cost to produce it. Maybe it never against equals its previous height. I truly don’t know. But it certainly was in a bubble and what happened is what always happens with bubbles. On December 17th, it peaked at $19,783. By June 28th, it was at $5,822, a loss of 71%. That’s a return that makes the first year of a whole life insurance policy look good.
# 2 Bitcoin is not, never has been, and given the current trade, is highly unlikely to ever function as a viable currency. Much of the hype driving this mania was that we were all going to start using Bitcoin as a currency. It was supposedly confidential, reliable, and out of the control of governments. Subsequent developments showed that none of that was the case. Besides, Bitcoin failed in the most elementary way – it simply didn’t function as a currency. Nobody was using it in any significant way to buy anything. Try it! Check your local area to see which businesses you can use Bitcoin at. I found about a dozen in the Salt Lake Valley, the largest of which repairs lawnmowers. Even those early adopters who tried to use it seem to be backing away from their decision. Try it yourself. Try to buy your next 30 purchases with Bitcoin and report back on how many of them you could use it for.
So if it isn’t the currency it pretends to be, what is it? It’s an instrument of speculation. Before costs, speculation is a zero–sum game. After costs, like roulette, it is a negative sum game. Don’t play negative-sum games.
As a high-income professional, you have an income in the top 1-3% of Americans. If you simply put 20% of your gross income away during your career and invest it in boring old stocks, bonds, and real estate, with a very high degree of reliability will have more money than you will ever need. You don’t need to speculate or buy stuff like Bitcoin in order to be financially successful, no matter how many seemingly smart people are doing so. Do yourself a favor and let this pitch go right by.
What do you think? Does trading or Bitcoin have a place in the portfolio of a serious investor? Why or why not? Comment below!
Mandatory Disclosure Material:
FUTURES TRADING IS SPECULATIVE & INVOLVES A HIGH DEGREE OF RISK. IT IS NOT SUITABLE FOR EVERYONE. THERE CAN BE NO ASSURANCE THAT THE STRATEGY WILL ACHIEVE ITS OBJECTIVES, RISK MANAGEMENT TECHNIQUES WILL BE SUCCESSFUL OR THAT LOSSES WILL BE AVOIDED. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
VIRTUAL CURRENCY DERIVATIVES DISCLOSURE: Purple Valley Capital, Inc. may trade Bitcoin futures. The underlying cash markets and exchanges for Bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority. This could lead to increased volatility and increased risk of loss. The initial margin for virtual currency derivatives may be set as a percentage of the value of a particular contract, which means that margin requirements for long positions can increase if the price of the contract rises. Exchanges may set higher margins for virtual currency derivatives than other market derivatives. Additionally, FCMs may require a margin level beyond the exchange minimums. FCMs may pose restrictions on customer trading activity in virtual currency derivatives, such as requiring additional margin, imposing position limits, prohibiting naked shorting or prohibiting give-in transactions. The rules of certain designated contract markets impose trading halts that may restrict a market participant’s ability to exit a position during a period of high volatility.