Bitcoin Remains Poorly Understood by Many

Bitcoin

Bitcoin is at least becoming more mainstream, with big institutions such as ICE and Fidelity coming on board. Our understanding of Bitcoin still has a long way to go though.

The fact that Bitcoin trading has started to mature a little, with it now being able to be traded on the futures market for instance, or the interest that institutions are starting to take in it now, doesn’t mean that we should expect the price to go up as a result of all of this.

It might if we take an overly simplistic view of it, like many do. The first obvious mistake is to call Bitcoin an investment, something that investors invest in, and this in itself can throw us off quite a bit. Sure, some people may actually invest in it, which means that they will buy it and then hold it for a significant period of time like they might do with a stock, but Bitcoin is nothing like a stock, and not even close actually, and certainly nothing we should ever want to “invest” in.

This leads to observations such as we are seeing right now where people wonder how Bitcoin is being more popular with institutions while investors are “languishing.” Beliefs like this really tip our hand and demonstrate that we really don’t know very much about how speculating on securities itself work, and that can indeed lead to confusion such as this.

Bitcoin trading actually offers us some very valuable lessons on how speculation works and how this affects all securities trading to some degree, although if we don’t know how speculation works in the first place, we will remain confused about not only Bitcoin but other investments as well, including stocks.

What stands out about Bitcoin is that it is a pure speculation, unfettered by reference points in the real world. With gold for instance, gold has other purposes aside from speculating on it and these other purposes will at least condition its price in some ways, even though this may be fairly limited. Even the Dutch tulip craze had tulips as a baseline. Bitcoin is intrinsically worthless and therefore has so such limitations.

Calling it worthless does not mean that it has no value, and far from it, it means that it has no value apart from its speculative value. It has plenty of that though and this is speculative value in its purest form, which is plenty interesting in itself.

We could not describe what goes on with Bitcoin overall as investing in any sense though, and we only have to look at the turnover to get very clear on this. Bitcoin’s daily volume as a percentage of its float ranges from 10-20% per day typically, resulting in a turnover every few days. Compared to anything else, this turnover level is insanely high.

We can deduce that the average holding time for Bitcoin is a little over a week. This isn’t investing and is as far away from investing as you could get. This is all happening without Bitcoin being used very much as a currency, and if it were used for this a lot more, this would only shorten the holding time.

Bitcoin is not invested in very much at all, nor would it make sense to given its volatility, and if there ever were a thing that was more unsuitable for investing in, Dutch tulips come to mind, but Bitcoin is clearly in second place all-time, with nothing else coming even close. This might not seem all that meaningful, but this should take us off of the idea that the value of this is its ability to appreciate over time, because the real value is in speculating on its price and looking to make money from trading it over time.

Bitcoin is Like A Highly Leveraged Commodity Without the Need to Leverage It

Bitcoin is much closer to a commodity than a stock, and it is only when we start thinking of it as a commodity that it can even start to make sense to us. Commodities, traded on the futures market, involve people looking to trade shorter-term price fluctuations, and this is what happens with Bitcoin trading as well, even though Bitcoin does this on steroids, and some powerful steroids at that.

There are still a lot of people out there that envision Bitcoin as like a stock, where you put money into it and save up for your retirement perhaps, like people do with index funds. This is as far away from an index fund as you can get and if you try to understand it that way you will just end up disappointed and be grinding your teeth over moves such as it losing 16% over the last month and a third of its value since August.

In order to invest in something, we have to at least have a good sense of where our investment will be during the period that we hope to hold it for, which with investing means years from now. We honestly don’t know all that much about this and certainly nowhere near enough that we should want to actually take this approach. This is seen as a failing of Bitcoin by those who want to understand it as an investment, but it’s this idea that it is or should be that is where the failure actually occurs.

Bitcoin is instead a trading vehicle, and it sure does trade. Without a proper understanding of trading, we’re going to end up pretty lost, and many are. This is actually trading in its purest form, where everything else is stripped away and all we have left is the forces of short-term speculation.

Bitcoin’s seemingly mysterious price movements are only mysterious if trading is mysterious to you, and especially if you think that the goal of most is to buy it and speculate on Bitcoin’s long-term prospects. It then may seem that Bitcoin “investors” got pretty excited for the first 7 months of the year, and then lost faith in it over the last 4, where this loss of interest resulted in a disappointing drop in price.

Those who have even a modest understanding of trading will just see this as being evidence of the very natural phenomenon of profit taking, where the price gets run up and then people start taking their profits, and when they take their profits this puts the price down. Bitcoin, being this volatile, can produce some big moves both ways and if we don’t get that, and try our best to bre on the right side of these moves, we’re really lost.

These people taking their profits were never in for the long haul, and once we start to descend the mountain, the momentum shifts and we start going down. Bitcoin mountains are very steep by nature, and if the climb is steep, the descent will be as well. This is one of the basic principles of trading actually, as well as it making a lot of sense in this case.

With the expansion of the Bitcoin futures market, which has only scratched the surface in terms of its reach, we also want to be careful not to view Bitcoin as only a one-sided asset. People make plenty of money when it goes down as well, which we do with all commodities that are traded. With the ability to profit in both directions, traders don’t even care which way it is moving so long as it is moving a lot. Bitcoin gives new meaning to the term “a lot.”

This is not to say that one could not invest in Bitcoin, and some do try to do this, although we need to understand how little sense this makes. If we consider how a lot of people approach stocks, there is a cost of efficiency to ride out all the ups and downs as opposed to looking to time them, but you can do quite well anyway just doing nothing with stocks due to their relative stability and long-term expectations.

Bitcoin is nothing like that though. The loss of efficiency by holding Bitcoin long-term is massive, massive enough to make this a crazy idea. Trading stocks can well beat a buy and hold approach with stocks but with Bitcoin, it slaughters it.

This doesn’t even take into account the additional risk you take on with this, where you are subject to slaughtering yourself. Buying and holding stocks requires that we accept the maximum risk of the market since we’ve chosen not to manage it, but if you try that with Bitcoin, the amount of risk we’re taking about is far greater, and that turns an idea that is less than optimal to one that is simply reckless.

All the people who have tried to steer us away from Bitcoin as an investment were actually right, and the part that they missed is that this should never be approached as an investment anyway but as a way to speculate on the price of something on a much shorter-term horizon, with the potential for huge gains. There’s also the potential for huge losses as well, so these positions have to be managed very carefully, much like we’d approach highly leveraged futures positions.

Bitcoin’s Lack of Popularity as a Currency Simply Doesn’t Matter

An even bigger myth, and one that is being talked about more lately, is the idea that Bitcoin could be worth a lot more if only it was used as an actual currency more. When we read remarks such as Bitcoin would be worth twice as much if it were accepted as a payment by Square, this shows us plainly how deep the misunderstanding about Bitcoin really runs.

Sure, this would increase the demand for Bitcoin as far as volume goes, but demand in volume and demand in price are actually not the same thing, and Bitcoin serves to beautifully illustrate this. The same thing happens with the trading of other securities such as stocks to a lesser degree, but still to one that it pays to be aware of, as this does impact the way the prices of stocks move as well.

It is not that people want it that puts up the price of something, it is how much they are willing to pay for it, and in an uptrend, they are willing to pay more due to their expecting the price to rise. This is very different from people just using Bitcoin more and it changing hands more, just like money doesn’t go up in value when people spend more of it.

Not only would seeing the demand for Bitcoin as a currency not put its price up, if anything, it would serve to stabilize it, which in the case of Bitcoin means flattening out these mountains. On the way up, speculative demand causes people to be willing to pay more, but this does not happen with its transactional demand, which actually prefers the opposite, stability over volatility.

It is actually pretty ridiculous to even think that transactional demand could run the price of Bitcoin up this much, as this is demand that does not want to pay more for it and therefore does not influence its price upward. Instead, what this would serve to do is water down the impact of Bitcoin’s now purely speculative demand and limit its potential upside, not double it.

It’s not that we have to worry about this though because Bitcoin and other cryptocurrencies are as far away from something that we would want to use as a currency as we could possibly get. Currencies derive their value from their stability, and Bitcoin is far too unstable to be useful for this other than with criminals who are willing to take on the extra risk to hide their activities. For the rest of us, this isn’t even close nor will it ever be considering that every trade is a forex trade and this foreign currency is rocket powered.

Bitcoin as a currency was always a dumb idea, unless you are a criminal of course, but we did get something useful emerging from this, which is a new asset that allows us to purely trade it. Anyone who thinks that it will ever replace hard currencies beyond being an insignificant niche just doesn’t understand.

In spite of what some may think, Bitcoin is plenty useful, as long as we understand what it is good for.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.