Bitcoin Shows Us Why We Need to Be Careful with It

Bitcoin

Tuesday was not an exciting day for those holding Bitcoin, as it dropped 14% in value in about an hour and a half. Neglecting the trends with Bitcoin can be very expensive.

Bitcoin has been on quite a ride in 2019, and is still up well over 100% for the year even after the big haircut that it has taken this month. The move down actually started back o August 7, where we touched the $12,000 mark. 6 weeks later, on Tuesday, it tested the $8,000 mark. We held, but $8400 is still a far cry from $12,000.

Unlike with the massive fall that Bitcoin from December 2017 to December 2018, where it lost 84%, we have a much better idea of the terrain than we did back then, when we truly were breaking new ground to the downside. Some speculated that this sell-off might take us all the way down, because there is no floor with cybercurrencies, no underlying value to fall back on that would keep price from going down to nothing.

With no intrinsic value, the Bitcoin market could dry up in theory, all the way down to a penny and no one trading at that price. That wasn’t really expected though, and as long as there is speculative interest, there will be someone to step in once the price drops too much, to play the rebound.

We did finally see this kick in last December, and we spent 7 months of onward and upward, and we made back over half of what was lost during the big fall. The second half of 2019 is not shaping up to be so kind though, so far at least.

September was shaping up to be an exciting month in the minds of many, with Bitcoin finally being rolled out to institutional investors with a new futures product being offered by Bakkt, a new company started by the ICE, which also owns the NYSE.

Bakkt is rolling out Bitcoin futures to institutional investors now. Bitcoin trading is essentially forex trading with a non-traditional currency as one of the pairs, and works just like other currency pairs, only it moves many times faster than any traditional currency pair.

The demand for Bakkt Bitcoin futures has been very disappointing so far, but we really should not be surprised given how these futures are set up. The hope is to get more institutional money involved in Bitcoin, but it may have been wishing for too much to expect futures contracts set up any way we choose would do very much to involve this market.

Institutions have been complaining that the Bitcoin market isn’t stable enough for them, so ICE got the idea that if they could come up with a futures product that was just offered to them, and settled in Bitcoin upon expiration instead of in cash like most futures, including the CME Bitcoin futures, then it might catch on with them more.

You can’t really escape the volatility though as this futures product will be subject to arbitrage like everything else traded on multiple markets, and the Bakkt product will essentially just tag along with the overall market. It has the potential to make a contribution by adding more liquidity, which the Bitcoin market could certainly benefit from, but it won’t add much if institutional investors remain on the shy side.

This idea therefore may have looked like a good one or at least one worth trying to ICE, who have been trying to roll this out since last year and finally managed to bring it to the market this week.

Bitcoin is Missing a Very Important Component of Futures Liquidity

The real problem with Bitcoin futures, whether offered to the public or to just institutions, is that we’re missing a critical component of a futures contract, the need to hedge what is traded. With physical commodities, both producers and consumers have a need to hedge to lock in future prices for the commodity on the buy and sell end, where producers can know how much they will make from future sales and consumers will know what these purchases will cost them down the road.

Financial futures don’t involve a physical good, but they are also used for hedging, for instance someone hedging their stock market positions by trading in futures, where if the value of their stocks go down this can be offset by gains in the futures market.

With forex futures, there are people wanting to hedge against currency risk, for instance if you get paid in a foreign currency and want to plan your production around getting paid in your own currency.

Bitcoin is a forex future but what is missing is the need to hedge. There’s really only one way to hedge Bitcoin risk and that’s to reduce or eliminate your position. You can’t hedge Bitcoin trading by trading Bitcoin. If you both held long and short positions, which is the most you could do, the smaller position could just be subtracted from the larger one with the same effect, where you just reduce your position instead.

You also can’t use Bitcoin to hedge against anything else, because that would be like trying to protect the risk from a match going off with a stick of dynamite instead. Hedging always requires risk reduction, and you can’t reduce it with something that is so much riskier than anything else.

With a normal futures market, we have the primary participants, who are the hedgers, along with speculators who essentially look to use trading techniques to make their trading more efficient, and gain a trading advantage over the primaries, who look to hedge their business risk at the expense of trading efficiency.

When we remove the hedgers, we’re just left with the speculators, and when we’re talking about speculating on something that is massively volatile, this speculation will just add to the volatility, not reduce it. With commodities, the goods themselves as well as the hedging place trading in a fairly tight range based upon what they can be expected to be worth at expiration in the real market, but Bitcoin does not have any such restraints, or any restraints really.

This is just not something that is going to be that popular with institutional investors, at least the ones that place any value at all upon stability. You could pick anything else I the world and it is going to be much more stable than a cybercurrency.

Bakkt Bitcoin futures hit the market at $9875 on Monday, and by the time Tuesday arrived, it was down to $8540, a loss of 14% in one day. Welcome to the wild and crazy world of Bitcoin.

There are massive amounts of money that can be made trading leveraged products that move this much, and massive amounts that can be lost as well, if you are on the wrong side of these moves. Bitcoin futures are not for the meek by any means, and this is the most extreme form of trading in the history of the world, not Bitcoin, but leveraged Bitcoin.

You can manage the risk of this but this takes risk management to the extreme as well, especially during times like this. This is just not the sort of thing that institutional traders prefer. Investing in Bitcoin is risky enough, but when this gets turbo charged, it gets even riskier.

The leverage with Bitcoin futures is really dialed down compared to other futures markets, but if you are only putting up 40% of the money, this does multiply its volatility by 2.5, and 2.5 times what is already a monster is a bigger monster. This 14% now becomes 35%, and we’re just talking a move of a single day here.

The risk of losing that much in a day, 35%, or even 14%, would scare the daylights out of most institutional investors. The risk profile of Bitcoin in general is more than enough to strike fear in their hearts. Bitcoin has proven to be a great investment so far over time, but has taken us on roller coaster rides that have been well beyond anything we’ve ever seen, and if we’re going to get on this ride, we need an extremely high tolerance for risk, way beyond the target market generally with this new futures product.

Bitcoin Demands a Close Eye

This is not to say that there won’t survive, but those who were thinking that the Bitcoin market was going to tame Bitcoin very much or that it would raise the liquidity of the Bitcoin market a lot were hoping more than they were thinking.

For those who have been speculating on Bitcoin in the Bitcoin market, this latest drama with it should serve to remind them that this indeed still a very dangerous product to trade. We always need to strive to both go after returns and manage risk, and both are required in adequate amounts to expect to do well.

This means that we need to pay attention to trends, and pay attention a lot more than we usually do, even as traders. The lengths of trends that we can look at differ, and we can trade this with one second bars or weekly ones as we prefer, but regardless, we need to be on the right side of whatever length of trend we are trading.

One of the real benefits of futures is that you can just as easily take a position that benefits when Bitcoin or whatever the underlying asset is drops in value. We’re actually in a down trend on that scale and just about every scale, so those who have been paying attention were in on the short side of it lately and profited handsomely from this latest move.

There are also some forex brokers who offer BTC/USD as a currency pair, and their margin requirements are much lower than the CMEs, but this is not a product you want to be using a lot more leverage with unless you are trading very short-term, the sort that you don’t go to the bathroom in a trade with unless you are taking your phone with you so that you can keep your eyes on the chart.

Futures trading with Bitcoin can therefore be quite helpful to certain traders who have the ability to keep their risk under control in this extreme trading environment, but that’s a fairly limited group. It doesn’t include much of the huge money that some think might be drawn into this game.

We do look like we’ve put in a bottom with this move, for now, although with Bitcoin being a pure momentum play, there’s little that stands in the way of selling pressure, as we just saw once again. Bitcoin may be maturing, but it’s still a kid, and kids often do not behave like adults, and this one is particularly hyperactive.

We need to realize that with trading, and especially with Bitcoin trading, things can happen very fast, and if we want to protect ourselves enough, which we must, we need to give it the respect it commands and ensure that we are raising our level of attention accordingly.

This week has been a bit of a wake-up call for some people, and while today’s Bitcoin may be a kinder and gentler version, kinder and gentler hurricanes are still hurricanes and must be treated that way.

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.